The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.87 and an expected return of 11.4 percent. Are these stocks correctly priced? Why or why not?
A) No; Stock A is underpriced and stock B is overpriced.
B) No; Stock A is overpriced and stock B is underpriced.
C) No; Stock A is overpriced but stock B is correctly priced.
D) No; Stock A is underpriced but stock B is correctly priced.
E) Yes; Both stocks are correctly priced.

Question

Quizplus · Accepted Answer

To determine if a stock is correctly priced, we need to compare its expected return with the return it should earn according to the CAPM using the risk-free rate, market risk premium, and its beta. Stock A has a higher expected return than what it should earn according to the CAPM (12.66%), indicating that it is overpriced. Stock B has a lower expected return than what it should earn according to the CAPM (12.05%), indicating that it is underpriced. Therefore, option B is the correct answer.

The Risk-Free Rate Is 4