Currently the risk-free rate equals 5% and the expected return on the market portfolio equals 11%. An investment analyst provides you with the following information:
|
Stock
|
Beta
|
Expected Return
|
|
A
|
1.33
|
12%
|
|
B
|
0.7
|
10%
|
|
C
|
1.5
|
14%
|
|
D
|
0.66
|
9%
|
a. Indicate whether each stock is overpriced, underpriced, or correctly priced.
b. For each stock, subtract the risk-free rate from the stock's expected return and divide the result by the stock's beta. For example, for asset A this calculation is (12% - 5%) ÷ 1.33. Provide an interpretation for these ratios. Which stock has the highest ratio and which has the lowest?
c. Show how a smart investor could construct a portfolio of stocks C and D that would outperform stock A.
d. Construct a portfolio consisting of some combination of the market portfolio and the risk-free asset such that the portfolio's expected return equals 9%. What is the beta of this portfolio? What does this say about stock D?
e. Divide the risk premium on stock C by the risk premium on stock D. Next, divide the beta of stock C by the beta of stock D. Comment on what you find.