Q:
A:
Stock A has a standard deviation of 16% and a beta of 1.1. Tbills 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 theÂ 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) 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.
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:
Â  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).
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