The risk-free rate is 7%. The expected market rate of return is 15%. If you expect a stock with a beta of 1.3 to offer a rate of return of 12%, you should
A) buy the stock because it is overpriced.
B) sell short the stock because it is overpriced.
C) sell the stock short because it is underpriced.
D) buy the stock because it is underpriced.
E) None of the options, as the stock is fairly priced.

Question

Quizplus · Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return = Risk-free rate + Beta * (Market return - Risk-free rate). Plugging in the numbers: 7% + 1.3 * (15% - 7%) = 17.4%. Since the expected return of 12% is less than the CAPM return of 17.4%, the stock is overpriced, and you should sell short.

The Risk-Free Rate Is 7