Question of the Week

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.

Answer:

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).