QUESTION 7 1 pointsSave Answer Stock A has an expected return of 12%, a beta of

Question

QUESTION 7 1 pointsSave Answer Stock A has an expected return of 12%, a beta of 1.2 and a standard deviation of20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has S 300,000 invested in Stock A and S 100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rAB-0). Which of the following statements is CORRECT? O a The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued Ob. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued Oa, Portfolio AB's expected return is 11.0%. Od. Portfolio AB's beta is less than 1.2 Portfolio AB's standard deviation is 17.5%. QUESTION 8 1 points Save Answer Assume that the risk-free rate is 5%, which of the following statements is CORRECT? a. If a stock's beta doubled, its required return under the CAPM would also double. b. If a stock has a negative beta, its required return under the CAPM would be less than 5%. Oo. If a stock's beta were less than 1 0, its required return uhder the CAPM would be less than 5%. O d. If a stock's beta doubled, its required return under the CAPM would more than double. e. If a stock's beta were 1.0, its required return under the CAPM would be 5%.

Explanation / Answer

7) Expected return as per CAPM is calculated as follows -

ER = Rf + Beta x (Rm - Rf)

where, Rf = risk free rate, Rm = return on market

Rf and Rm will be same for both the stocks. The only difference would be beta. But, beta is also equal in our case. Therefore, in equilibrium, the expected returns of both the stocks should be equal as they have the same beta. If A is valued correctly at 12%, then B would be undervalued 10%. (Option a)

8) Option b is correct. We have the following info -

ER = Rf + beta x (Rm - Rf)

Or, ER = 5% + beta x (Rm - Rf)

Now, if beta was negative, then any value of the market risk premium (Rm - Rf) multiplied by the negative beta will give a negative value, which would be deducted from 5%. Therefore, return would be less than 5%.

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