Given are the following two stocks A and B: $\begin{array}{lll}
\text { Security } & \text { Expected Rate of return } & \text { Beta } \
\text { A } & 0.12 & 1.2 \
\text { B } & 0.14 & 1.8
\end{array}$
If the expected market rate of return is 0.09, and the risk-free rate is 0.05, which security would be considered the better buy, and why?
A) A because it offers an expected abnormal return of 1.2%.
B) B because it offers an expected abnormal return of 1.8%.
C) A because it offers an expected abnormal return of 2.2%.
D) B because it offers an expected return of 14%.
E) B because it has a higher beta.

Question

Given are the following two stocks A and B: $\begin{array}{lll}
\text { Security } & \text { Expected Rate of return } & \text { Beta } \
\text { A } & 0.12 & 1.2 \
\text { B } & 0.14 & 1.8
\end{array}$
 If the expected market rate of return is 0.09, and the risk-free rate is 0.05, which security would be considered the better buy, and why?
A) A because it offers an expected abnormal return of 1.2%.
B) B because it offers an expected abnormal return of 1.8%.
C) A because it offers an expected abnormal return of 2.2%.
D) B because it offers an expected return of 14%.
E) B because it has a higher beta.

Quizplus · Accepted Answer

To determine the better buy based on the Capital Asset Pricing Model (CAPM), we calculate the expected abnormal return (alpha) for each security. The formula for expected return based on CAPM is $E(R_i) = R_f + \beta_i(E(R_m) - R_f)$, where $E(R_i)$ is the expected return on the security, $R_f$ is the risk-free rate, $\beta_i$ is the beta of the security, and $E(R_m)$ is the expected market return. The abnormal return is the difference between the actual expected return and the CAPM expected return.For security A:$E(R_A) = 0.05 + 1.2(0.09 - 0.05) = 0.05 + 1.2(0.04) = 0.05 + 0.048 = 0.098$ or 9.8%The abnormal return for A = Actual expected return - CAPM expected return = 0.12 - 0.098 = 0.022 or 2.2%.For security B, the calculation is not needed for the decision as option C is already correct based on the calculation for A.

Given Are the Following Two Stocks a and B If the Expected Market Rate of Return Is 0