Stock Y has a beta of 1.2 and an expected return of 11.1 percent. Stock Z has a beta of .80 and an expected return of 7.85 percent. If the risk-free rate is 2.4 percent and the market risk premium is 7.2 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 (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e. g., 32.16.)

Stock Y is undervalued.

Stock Z is overvalued.

Reward to risk ratio = (Expected return of stock - Risk free rate of return) ÷ Beta of stock

Reward to Risk ratio

= (11.1% - 2.4%) ÷ 1.2

= 7.25 %

Reward to Risk ratio

= (7.85% - 2.4%) ÷ 0.80

= 6.8125%

Also,  

SML reward to Risk ratio should always be equivalent to the market Risk premium  i.e 7.20%  

Therefore we can conclude Stock Y is undervalued.  and Stock Z is overvalued.

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Answer and Explanation:

As we know that

Reward to risk ratio = (Expected return of stock - Risk free rate of return) ÷ Beta of stock

For stock Y, it is

Reward to Risk ratio

= (11.1% - 2.4%) ÷ 1.2

= 7.25 %

For stock Z, it is

Reward to Risk ratio

= (7.85% - 2.4%) ÷ 0.80

= 6.8125%

And,

SML reward to Risk ratio should always market Risk premium  i.e 7.20%

As we can see that

Stock Y has higher reward  to Risk ratio i.e 7.25% than SML i.e 7.20% , so it is underpriced or undervalued.

And,

Stock Z has lower reward to Risk ratio i.e 6.8125% than SML i.e 7.20%, so it is overpriced or overvalued.

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