The risk-free rate is 4%. The expected market rate of return is 11%. If you expect CAT with a beta of 1.0 to offer a rate of return of 10%, you should
A) buy CAT because it is overpriced.
B) sell short CAT because it is overpriced.
C) sell short CAT because it is underpriced.
D) buy CAT because it is underpriced.
E) None of the options, as CAT is fairly priced.

Question

Quizplus · Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return for CAT (given its beta of 1.0) should equal the risk-free rate plus the product of its beta and the market risk premium (expected market rate of return minus the risk-free rate). This calculation yields an expected return of 7% (4% + 1.0*(11%-4%)). Since the actual expected return of 10% is higher than this, it indicates that CAT is overpriced, suggesting a sell short strategy.

The Risk-Free Rate Is 4