We have the following information on Stocks A and B. The risk-free rate is 5%, a

Question

We have the following information on Stocks A and B. The risk-free rate is 5%, and the market risk premium is 6.25%. Assume that the market portfolio is correctly priced. Based on the reward-to-risk ratio, are Stocks A and B overpriced, underpriced, or correctly priced?

Stock A

Stock B

Expected return

10%

15%

Beta

0.8

1.5

Select one:

a. A is underpriced; B is overpriced.

b. A is correctly priced; B is overpriced.

c. A is overpriced; B is underpriced.

d. A is correctly priced; B is underpriced.

e. Both stocks are correctly priced.

Stock A

Stock B

Expected return

10%

15%

Beta

0.8

1.5

Explanation / Answer

required return on A = 5% + 0.8*6.25% = 10%...........so correctly price

required return on B = 5% + 1.5*6.25% = 14.375%......so underpriced

d. A is correctly priced; B is underpriced.

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