Stock Y has a beta of 1.0 and an expected return of 12.4 percent. Stock Z has a beta of .6 and an expected return of 8.2 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.4 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

Reward-to-risk for stock Y = (0.124 - 0.052) / 1 = 0.072 = 7.2%

Reward-to-risk for stock Z = (0.082 - 0.052) / 0.6 = 0.05 = 5%

SML reward to risk is beta of market. i.e., 6.4%

Explanation:

Answer;

Reward-to-risk ratio of Y = 7.2%

Reward-to-risk ratio of Z = 5%

Explanation:

Stock Y

reward-to-risk ratio of Y = (12.4%-5.2%)/1= 7.2%

reward-to-risk ratio of Z = (8.2%-5.2%)/0.6= 5%

SML reward-to-risk = 6.4%/1= 6.4%

Therefore the reward-to-risk ratio for Stock Y is very high, meaning the stock plots above the SML, and the stock is undervalued. Hence, Its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

The reward-to-risk ratio for Stock Z is very low, which simply means the stock plots below the SML, and the stock is overvalued. Hence Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio.

Therefore If the risk-free rate is 5.2 percent and the market risk premium is 6.4percent, the reward-to-risk ratios for stocks Y and Z are 7.2 and 5 percent, respectively. Since the SML reward-to-risk is 6.4 percent, Stock Y is undervalued and Stock Z is overvalued.

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