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. 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 ...
  3. 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 ...
  4. 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 ...
  5. 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 ...
  6. How does beta measure a stock's market risk?

    Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ...
RELATED TERMS
  1. Expected Return

    The amount one would anticipate receiving on an investment that ...
  2. Annualized Total Return

    The average amount of money earned by an investment each year ...
  3. Abnormal Return

    A term used to describe the returns generated by a given security ...
  4. Return

    The gain or loss of a security in a particular period. The return ...
  5. Capital Allocation Line - CAL

    A line created in a graph of all possible combinations of risky ...
  6. Intraday Return

    One of the two components of the total daily return generated ...
Trading Center