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%
Required:
1. Indicate whether each stock is overpriced, underpriced, or correctly priced. (9 marks)
2. 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%) divide 1.33. Provide an interpretation for these ratios. Which stock has the highest ratio and which has the lowest? (8 marks)
3. Show how a smart investor could construct a portfolio of stocks C and D that would outperform stock A. (7 marks)
4. 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?
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