Stock Y has a beta of 1.10 and an expected return of 15.60 percent. Stock Z has

Question

Stock Y has a beta of 1.10 and an expected return of 15.60 percent. Stock Z has a beta of .70 and an expected return of 10 percent. If the risk-free rate is 4.0 percent and the market risk premium is 9.0 percent, what are the reward-to-risk ratios of Y and Z? (Do not round intermediate calculations. Round your answers to 4 decimal places.)

Stock Y has a beta of 1.10 and an expected return of 15.60 percent. Stock Z has a beta of .70 and an expected return of 10 percent. If the risk-free rate is 4.0 percent and the market risk premium is 9.0 percent, what are the reward-to-risk ratios of Y and Z? (Do not round intermediate calculations. Round your answers to 4 decimal places.)

Explanation / Answer

Answer: Reward to Risk Ratio=(Expected return-Risk free rate)/Beta

Y=(15.60%-4%)/1.10=0.1054

The reward-to-risk ratio for Stock Y is too high, which means the stock plots above the SML, and the stock is undervalued. Its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

Z=(10%-4%)/0.70=0.08571

The reward-to-risk ratio for Stock Z is too low, which means the stock plots below the SML, and the stock is overvalued. Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

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