Q:
Stock A has a standard deviation of 16% and a beta of 1.1. T-bills are currently yielding 3.7% on an annualized basis. The expected return on the market index is 9.1%, while its standard deviation is 14.9%. If Stock B is expected to earn 10.51% and it is of equal risk to Stock A, which of the following statements would be the most accurate?
A) Since Stock A has an expected return of 11.41%, it must be underpriced.
B) Since Stock A has an expected return of 11.41%, it must be overpriced.
C) Since Stock A has an expected return of 9.64%, it must be overpriced.
D) Since Stock A has an expected return of 9.64%, it must be underpriced.
A:

The correct answer is: C)
Step 1: Calculate the expected return on Stock A
E(R) = (.10)(12%) + (.25)(15%) + (.40)(8%) + (.25)(-9%)
= 1.2% + 3.7% + 3.2% + -2.2%
= 5.9%

Step 2: Relative comparison:

 
E(R)
Stock A
9.64%
Stock B
10.51%

Step 3: Conclusion
Stock A is overpriced (this result is from the lower expected return).


RELATED FAQS

  1. A manager wishes to construct a portfolio by investing 25% in a stock half as volatile ...

    The correct answer is: b) Step 1. Find Portfolio Beta Beta of the Portfolio = (.25)(.5)+(.25)(2)+(.25)(1)+(.25)(0) = 0.125 ...
  2. What two components are used to calculate risk-adjusted return? I ...

    The correct answer is b. Standard deviation and the risk-free rate of return are used to calculate or measure return based ...
  3. How does my insurance company determine what premiums I have to pay for coverage?

    Learn about some of the quantitative finance measures that investors without a strong math background can use in analyzing ...
  4. How is risk aversion measured in Modern Portfolio Theory (MPT)?

    Find out how risk aversion is measured in modern portfolio theory (MPT), how it is reflected in the market and how MPT treats ...
  5. What is the difference between standard deviation and average deviation?

    Understand the basics of standard deviation and average deviation, including how each is calculated and why standard deviation ...
  6. How is standard deviation used to determine risk?

    Understand the basics of calculation and interpretation of standard deviation and how it is used to measure risk in the investment ...
RELATED TERMS
  1. Expected Return

    The amount one would anticipate receiving on an investment that ...
  2. Standard Deviation

    1. A measure of the dispersion of a set of data from its mean. ...
  3. Downside Deviation

    A measure of downside risk that focuses on returns that fall ...
  4. Abnormal Return

    A term used to describe the returns generated by a given security ...
  5. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
  6. Capital Allocation Line - CAL

    A line created in a graph of all possible combinations of risky ...
Trading Center