Stock A has an expected return of 12%,a beta of 1.2,and a standard deviation of 20%.Stock B also has a beta of 1.2,an expected return of 10%,and a standard deviation of 15%.Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B.The correlation between the two stocks' returns is zero (that is,r_A,B = 0).Which of the following statements is correct? A)The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued. B)The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued. C)Portfolio AB's expected return is 11.0%. D)Portfolio AB's beta is less than 1.2.

Question

Quizplus · Accepted Answer

According to the CAPM, the expected return for a stock is equal to the risk-free rate plus its beta multiplied by the market risk premium. As both stocks have the same beta, their expected returns should be the same if they are in equilibrium. However, Stock B has a lower expected return and a lower standard deviation than Stock A, which indicates that it is undervalued compared to Stock A. 
Since the correlation between the two stocks' returns is zero, there are no diversification benefits from combining them in a portfolio. The expected return of Portfolio AB is calculated as the weighted average of the individual stock's expected returns:

Expected return of Portfolio AB = (900,000/1,200,000) x 12% + (300,000/1,200,000) x 10% = 11.0%

Therefore, Choice A is correct.

Stock a Has an Expected Return of 12%,a Beta of 1.2,and