Stock Y has a beta of 1.8 and an expected return of 18.2 percent. Stock Z has a

Question

Stock Y has a beta of 1.8 and an expected return of 18.2 percent. Stock Z has a beta of .8 and an expected return of 9.6 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.7 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)undervaluedovervalued and Stock Z is (Click to select)overvaluedundervalued.(Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal

Stock Y has a beta of 1.8 and an expected return of 18.2 percent. Stock Z has a beta of .8 and an expected return of 9.6 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.7 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)undervaluedovervalued and Stock Z is (Click to select)overvaluedundervalued.(Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal

Explanation / Answer

Now, SML reward to risk ratio = Market risk premium = 0.067

Since market has a beta of 1.

For Stock Y, reward to risk ratio = (Expected return - risk free rate)/beta

= (0.182 - 0.052)/1.8

= 0.072

Which is greater than SML reward to risk ratio, this means it is above SML line, hence it is undervalued.

For stock Z, reward to risk ratio = (0.096-0.052)/0.8

= 0.055

Which is less than SML reward to risk ratio, this means it is below SML line, hence it is overvalued.

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