Question

In: Finance

You have the following information about three securities A, B, and C: Security Expected return Beta...

You have the following information about three securities A, B, and C:

Security	Expected return	Beta
A	24%	2.0
B	7%	0.5
C	2%	0

Given this information, you can definitely conclude that:

A.
All three securities are underpriced
B.
A, B, and C are fairly priced
C.
At least two of the three securities are mispriced
D.
At least one of A, B, or C is mispriced

Expert Solution

If CAPM holds, we have following formula to calculate the expected return on stocks

Expected Return of the stock = risk free rate + β* the market risk premium

As the beta of security C is 0, therefore we can assume that its expected return is risk free rate

Now

Expected Return of the stock A = 24%

Risk free rate = 2%

The market risk premium =?

And β of stock A = 2.0

Putting all the values in the equation we can get

24% = 2% + 2.0 * the market risk premium

Or market risk premium = (24% -2%)/2 = 11%

Similarly for stock B

Expected Return of the stock B = 7%

Risk free rate = 2%

The market risk premium =11% (as calculated above)

And β of stock B = 0.5

Putting all the values in the equation we can get

7% = 2% + 0.5 * 11%

Or 7% ≠ 7.5%

Based on these values, it is a violation of CAPM model because the betas and expected returns are not consistent with CAPM.

Therefore At least one of A, B, or C is mispriced

Correct answer is option: D. At least one of A, B, or C is mispriced

jeff jeffy answered 1 year ago

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