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 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 ...
  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. 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 ...
  6. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ...
RELATED TERMS
  1. Standard Deviation

    1. A measure of the dispersion of a set of data from its mean. ...
  2. Risk-Adjusted Return

    A concept that refines an investment's return by measuring how ...
  3. Residual Standard Deviation

    A statistical term used to describe the standard deviation of ...
  4. Return

    The gain or loss of a security in a particular period. The return ...
  5. Intraday Return

    One of the two components of the total daily return generated ...
  6. Dispersion

    A statistical term describing the size of the range of values ...
Trading Center