Which one of the following stocks is correctly priced if the risk-free rate of return is 3.9 percent and the market risk premium is 8.4 percent?

stock beta expected return
a 0.77 7.86%
b 1.55 12.65%
c 1.36 17.33%
d 1.33 11.93%
e 0.95 11.88%

E 0.95 11.88%

Explanation:

First we have to calculate the market return from market risk premium using the following formula:

Market risk premium=Market return-Risk free return

Market return=3.9%+8.4%=12.3%

Above market return will be applied to the Capital asset pricing model formula for the purpose of calculating expected return.

CAPM=Risk free return+Beta(Market return-Risk free return)

A.

Expected return=3.9%+0.77(12.3%-3.9%)=10.37%

Incorrect because the expected return is 10.37% as compared to the 7.86% given in question.

B.

Expected return=3.9%+1.55(12.3%-3.9%)=16.92%

Incorrect because the expected return is 16.92% as compared to the 12.65% given in question.

C.

Expected return=3.9%+1.36(12.3%-3.9%)=15.32%

Incorrect because the expected return is 15.32% as compared to the 17.33% given in question.

D.

Expected return=3.9%+1.33(12.3%-3.9%)=15.072%

Incorrect because the expected return is 15.072% as compared to the 11.93% given in question.

E.

CAPM=3.9%+0.95(12.3%-3.9%)=11.88%

Correct because the expected return is 11.88% as given in question.

So the correct option is E.

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