Stock Y has a beta of 1.8 and an expected return of 18.3 percent. Stock Z has a

Question

Stock Y has a beta of 1.8 and an expected return of 18.3 percent. Stock Z has a beta of 1.0 and an expected return of 11.3 percent. If the risk-free rate is 5.6 percent and the market risk premium is 6.6 percent, the reward-to-risk ratios for stocks Y and Z are Since the SML reward-to-risk is and percent, respectively. percent, Stock Y is (Click to select) and Stock Z is (Click to select) (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation / Answer

Reward to Risk ratio for market = 6.6%

Reward to Risk ratio for Stock Y = (18.3% - 5.6%)/ 1.8

Reward to Risk ratio for Stock Y = 7.06%

Reward to risk ratio for stock Y is too high which means it plot above the SML and the stock is undervalued. Since the SML reward to risk is 6.6%. Its price must increase untill its reward to risk become equal to market reward to risk

Reward to Risk ratio for Stock Z = (11.3% - 5.6%)/ 1

Reward to Risk ratio for Stock Z = 5.7%

Reward to risk ratio for stock Z is too low which means it plot below the SML and the stock is overvalued. Since the SML reward to risk is 6.6%. Its price must decrease untill its reward to risk become equal to market reward to risk

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