Stock Y has a beta of 1.4 and an expected return of 17.0 percent. Stock Z has a

Question

Stock Y has a beta of 1.4 and an expected return of 17.0 percent. Stock Z has a beta of 0.7 and an expected return of 10.1 percent. If the risk-free rate is 6.0 percent and the market risk premium is 7.2 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)undervaluedovervalued. (Round your answers to 2 decimal places. (e.g., 32.16))

Stock Y has a beta of 1.4 and an expected return of 17.0 percent. Stock Z has a beta of 0.7 and an expected return of 10.1 percent. If the risk-free rate is 6.0 percent and the market risk premium is 7.2 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)undervaluedovervalued. (Round your answers to 2 decimal places. (e.g., 32.16))

Explanation / Answer

Stock Y has a beta of 1.4 and an expected return of 17.0 percent. Stock Z has a beta of 0.7 and an expected return of 10.1 percent. If the risk-free rate is 6.0 percent and the market risk premium is 7.2 percent, the reward-to-risk ratios for stocks Y and Z are 7.86 and 5.86 percent, respectively. Since the SML reward-to-risk is 7.2 percent, Stock Y is undervalued and Stock Z is overvalued.

Reward to risk ratio = (expected return – risk free rate ) / beta

Reward to risk ratio of stock y = (17 – 6) / 1.4

= 7.86%

Reward to risk ratio of stock z = (10.1 – 6) / 0.7

= 5.86%

Reward to risk ratio of market = 7.2 / 1

=7.2%

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