You have been asked to analyze two stocks,Stock A and Stock B.The beta of stock A is 1.2,and the beta of stock B is 0.8.The expected return on stock A is 13.5%,the expected return on stock B is 11.0% and the risk-free rate is 7%.We also know that stock A is fairly priced.Which of the following regarding Stock B must be true?
A) The expected return on stock A is too high.
B) Stock B is also fairly priced.
C) The price of stock B is too high.
D) The expected return on stock B is too high.

Question

Quizplus · Accepted Answer

Since we know that Stock A is correctly priced, the CAPM should hold: E(k_i) = k_F + β_i[E(k_M) - k_F] 0.135 = 0.07 + 1.2[E(k_M) - k_F] We can now solve for the market risk premium, [E(k_M) - k_F]. 0.065 = 1.2[E(k_M) - k_F] [E(k_M) - k_F] = 0.0541667 Using the Market Risk Premium, we can now calculate the fair expected return of Stock B: E(k_i) = k_F + β_i[E(k_M) - k_F] E(k_i) = 0.07 + 0.8(0.0541667) E(k_i) = 0.07 + 0.0433333 = 0.1133 or 11.33% Since 11.33% > 11.0%, the fair expected return of Stock B, as implied by the CAPM, is greater than the actual return of stock B. Therefore, Stock B is priced too high (it is overvalued).

You Have Been Asked to Analyze Two Stocks,Stock a and Stock