Stock Y has a beta of .9 and an expected return of 11.2 percent. Stock Z has a b

Question

Stock Y has a beta of .9 and an expected return of 11.2 percent. Stock Z has a beta of .5 and an expected return of 7.2 percent. If the risk-free rate is 5 percent and the market risk premium is 6 percent, the reward-to-risk ratios for stocks Y and Z are  and  percent, respectively. Since the SML reward-to-risk is  percent, Stock Y is (Click to select)overvaluedundervalued and Stock Z is (Click to select)overvaluedundervalued. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Solution:

Using Reward-to-risk ratio

For Stock Y

Reward-to-risk ratio Y = (0.112 - 0.050) / 0.9

                   = 0.06888

The reward-to-risk ratio for Stock Y is too high viz., above the SML and the stock is undervalued.

Therefore its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

For Stock Z.

Reward-to-risk ratio Z = (0.072 - 0.050) / 0.5

                   = 0.044.

The reward-to-risk ratio for Stock Z is too low viz., below the SML, and the stock is overvalued.

Therefore its price must decrease until its reward-to-risk ratio

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