Stock Y has a beta of 1.4 and an expected return of 14.7 percent. Stock Z has a beta of .7 and an expected return of 8.7 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.2 percent, the reward-to-risk ratios for stocks Y and Z are and percent, respectively. Since the SML reward-to-risk is percent, Stock Y is and Stock Z is

Stock Y is undervalued  because the reward-to-risk ratio for Stock Y is higher than the SML

Stock Z is overvalued  because the reward-to-risk ratio for Stock Z is lower than the SML

Explanation:

From the question,

It is given:

FOR STOCK Y

Stock expected return = 14.7%

Stock beta = 1.4

risk-free rate is 5.2%

The Reward-to-risk ratio is given by the difference between the stock expected return and risk free rate divided by the stock beta.

Therefore

Reward-to-risk ratio for stock Y = (14.7% - 5.2%)/1.4

= 6.79%

FOR STOCK Z

Stock expected return = 8.7%

Stock beta = 0.7

risk-free rate is 5.2%

Therefore

Reward-to-risk ratio for stock Z = (8.7% - 5.2%)/0.7

= 5%

FOR SML

market risk premium = 6.2%

Risk rate = 5.2

Therefore

Reward-to-risk ratio for SML = (6.2%)/6.2 - 5.2

= 6.20%

Stock Y is undervalued  because the reward-to-risk ratio for Stock Y is higher than the SML

Stock Z is overvalued  because the reward-to-risk ratio for Stock Z is lower than the SML

Reward to risk

Stock Y = 6.28%

Stock Z = 5%

SML = 6.2%

Stock Y is Undervalued

Stock Z is overvalued

Explanation:

In order to calculate the reward to risk ratio we need the reward/ER of stock and the risk

Stock Y = β 1.4, ER 14.7%

Stock Z = β 0.7 , ER 8.7%

rf = 5.2% rmp =6.2%

Reward to Risk Ratio

For Y

=(14.7-5.2)/1.4 =0.0628/6.28%

For Z

=(8.7-5.2)/0.7 =0.05/5%

SML is the reward to risk ratio of the market we are given market risk premium of the market and we know that the beta of market is 1

(6.2)/1=6.2%

The reward-to-risk ratio for Stock Y is  higher than the market reward-to-risk ratio,  meaning which the stock plots above the SML, and the stock is undervalued.

The reward-to-risk ratio for Stock Z is  lower than the market reward-to-risk ratio,  meaning which the stock plots above the SML, and the stock is overvalued.

The prices of these stocks must increase/ decrease until they equal Reward-to-risk of the market

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