Calculate the required return of a security with a beta of 1.35 and an expected

Question

Calculate the required return of a security with a beta of 1.35 and an expected rate of return of 15%. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

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The risk-free rate is 5% and the expected rate of return on the market portfolio is 12%. The risk-free rate is 5% and the expected rate of return on the market portfolio is 12%. a. Calculate the required return of a security with a beta of 1.35 and an expected rate of return of 15%. (Do not round intermediate calculations. Round your answer to 2 decimal places.) Required return 0 b. Is the security overpriced or underpriced? O Underpriced Overpriced

Explanation / Answer

Answer (a)

Required return

%

14.45

Answer (b)

The stock is Under-priced

Risk free rate rf= 5%

Return on Market Portofolio rm = 12%

Security’s Beta s = 1.35

Required rate of return E(rs) = rf + s (rm – rf)

                                                   = 5% + 1.35 (12% – 5%)

                                                  = 5% + 1.35 * 7%

                                                 = 5% + 9.45%   = 14.45%

As the expected return is more than the require return, the demand for the stock will be more so that the price rises to such a level that the expected return equals required return. That is the stock is currently underpriced.

Required return

%

14.45

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