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solfinal - 19 There are two ways to correctly answer this...

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19. There are two ways to correctly answer this question. We will work through both. First, we can use the CAPM. Substituting in the value we are given for each stock, we find: E(R Y ) = .08 + .075(1.30) = .1775 or 17.75% It is given in the problem that the expected return of Stock Y is 18.5 percent, but according to the CAPM, the return of the stock based on its level of risk, the expected return should be 17.75 percent. This means the stock return is too high, given its level of risk. Stock Y plots above the SML and is undervalued. In other words, its price must increase to reduce the expected return to 17.75 percent. For Stock Z, we find: E(R Z ) = .08 + .075(0.70) = .1325 or 13.25% The return given for Stock Z is 12.1 percent, but according to the CAPM the expected return of the stock should be 13.25 percent based on its level of risk. Stock Z plots below the SML and is overvalued. In other words, its price must decrease to increase the expected return to 13.25 percent. We can also answer this question using the reward-to-risk ratio. All assets must have the same reward-to-risk ratio. The reward-to-risk ratio is the risk premium of the asset divided by its β . We are given the market risk premium, and we know the β
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