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 is the difference between the expected return and the standard deviation of ...

    Learn about the expected return and standard deviation and the difference between the expected return and standard deviation ...
  3. Stocks with a positive alpha are considered to be underpriced ...

    The correct answer is a): The risk-adjusted return attempts to measure the risks taken to achieve a desired return. Alpha ...
  4. 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 ...
  5. What does standard deviation measure in a portfolio?

    Dig deeper into the investment uses of, and mathematical principles behind, standard deviation as a measurement of portfolio ...
  6. What is standard deviation used for in mutual funds?

    See how standard deviation is helpful in evaluating a mutual fund's performance. Use it in combination with other measurements ...
RELATED TERMS
  1. Standard Deviation

    1. A measure of the dispersion of a set of data from its mean. ...
  2. Underpricing

    The pricing of an initial public offering (IPO) below its market ...
  3. Risk

    The chance that an investment's actual return will be different ...
  4. Residual Standard Deviation

    A statistical term used to describe the standard deviation of ...
  5. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
  6. Downside Deviation

    A measure of downside risk that focuses on returns that fall ...
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center