Stock Y has a beta of 1.6 and an expected return of 20 percent. Stock Z has a be

Question

Stock Y has a beta of 1.6 and an expected return of 20 percent. Stock Z has a beta of 1.2 and an expected return of 10 percent. If the risk-free rate is 4.8 percent and the market risk premium is 6.82 percent, the reward-to-risk ratios for stocks Y and Z are what percent and what percent, respectively. Since the SML reward-to-risk is what percent, Stock Y is undervalued, overvalued, or correctly priced and Stock Z isundervalued, overvalued, or correctly priced. (Do not include the percent signs (%). Round your answers to 2 decimal places. (e.g., 30.12))

Explanation / Answer

Reward-to-risk ratio: A ratio used by many investors tocompare the expected returns on an investment to the amount of risk undertaken to capture these returns. According to the given data, Stock Y: Expected return E(R) = 20% Beta of stock Y = 1.6 Stock Z: Expected return E (R) = 10% Betaof stock Z (ßz) = 1.2 Risk-free rate is 4.8%; Market risk premium is 6.82% Calculation of Reward-to-Risk ratio: This ratio is calculated as [E(R) - Rf ]/Beta value By using this equation we can find the Reward-to-risk ratiofor the two stocks separately. For Stock Y: Let us calculatethis ratio for Stock Y (20% - 4.8%)/1.6 = 9.5% For Stock Z: let us calculate this ratio for Stock Z (10% - 4.8%)/1.2= 4.33% Conclusion: The component [E(R) -Rf ] is the reward the market offers for bearing an average amount of systematic risk Finally, what we conclude is that Stock Z offers an insufficient expected return for its level of risk, at least relative to Stock Y. Since, its expected return is too low, its price is too high. Hence, Stock Z is overvalued relative to Stock Y. In other words, we can also say that Stock Y is undervalued relative to Stock Z.

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