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31 August, 08:03

Stock Y has a beta of 1.4 and an expected return of 14.7 percent. Stock Z has a beta of. 7 and an expected return of 8.7 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.2 percent, the reward-to-risk ratios for stocks Y and Z are and percent, respectively. Since the SML reward-to-risk is percent, Stock Y is and Stock Z is

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  1. 31 August, 11:47
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    Stock Y is undervalued because the reward-to-risk ratio for Stock Y is higher than the SML

    Stock Z is overvalued because the reward-to-risk ratio for Stock Z is lower than the SML

    Explanation:

    From the question,

    It is given:

    FOR STOCK Y

    Stock expected return = 14.7%

    Stock beta = 1.4

    risk-free rate is 5.2%

    The Reward-to-risk ratio is given by the difference between the stock expected return and risk free rate divided by the stock beta.

    Therefore

    Reward-to-risk ratio for stock Y = (14.7% - 5.2%) / 1.4

    = 6.79%

    FOR STOCK Z

    Stock expected return = 8.7%

    Stock beta = 0.7

    risk-free rate is 5.2%

    Therefore

    Reward-to-risk ratio for stock Z = (8.7% - 5.2%) / 0.7

    = 5%

    FOR SML

    market risk premium = 6.2%

    Risk rate = 5.2

    Therefore

    Reward-to-risk ratio for SML = (6.2%) / 6.2 - 5.2

    = 6.20%

    Stock Y is undervalued because the reward-to-risk ratio for Stock Y is higher than the SML

    Stock Z is overvalued because the reward-to-risk ratio for Stock Z is lower than the SML
  2. 31 August, 11:48
    0
    Reward to risk

    Stock Y = 6.28%

    Stock Z = 5%

    SML = 6.2%

    Stock Y is Undervalued

    Stock Z is overvalued

    Explanation:

    In order to calculate the reward to risk ratio we need the reward/ER of stock and the risk

    Stock Y = β 1.4, ER 14.7%

    Stock Z = β 0.7, ER 8.7%

    rf = 5.2% rmp = 6.2%

    Reward to Risk Ratio

    For Y

    = (14.7-5.2) / 1.4 = 0.0628/6.28%

    For Z

    = (8.7-5.2) / 0.7 = 0.05/5%

    SML is the reward to risk ratio of the market we are given market risk premium of the market and we know that the beta of market is 1

    (6.2) / 1=6.2%

    The reward-to-risk ratio for Stock Y is higher than the market reward-to-risk ratio, meaning which the stock plots above the SML, and the stock is undervalued.

    The reward-to-risk ratio for Stock Z is lower than the market reward-to-risk ratio, meaning which the stock plots above the SML, and the stock is overvalued.

    The prices of these stocks must increase / decrease until they equal Reward-to-risk of the market
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