Stock Y has a beta of 1.4 and an expected return of 17 percent. Stock Z has a be

Question

Stock Y has a beta of 1.4 and an expected return of 17 percent. Stock Z has a beta of .7 and an expected return of 10.1 percent. If the risk-free rate is 6 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 undervalue/overvalue and Stock Z is undervalue/overvalue . (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

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Explanation / Answer

solution :

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(Beta of market is always 1)

=7.2%

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