The risk-free rate is 4%. The expected market rate of return is 11%. If you expect share X with a beta of .8 to offer a rate of return of 12 per cent, then you should ________.
A)buy share X because it is overpriced
B)buy share X because it is underpriced
C)sell short share X because it is overpriced
D)sell short share X because it is underpriced

Question

Quizplus · Accepted Answer

According to the Capital Asset Pricing Model, the expected rate of return for any stock should be equal to the risk-free rate plus the product of its beta and the difference between the expected market rate of return and the risk-free rate. In this case, the expected rate of return for share X, using the CAPM formula, is:

Expected return = 4% + 0.8 * (11% - 4%) = 9.2%

Since the expected return for share X is higher than the required rate of return, the stock is undervalued, and it is a good investment opportunity. Therefore, you should buy share X.

The Risk-Free Rate Is 4