You have observed the following returns over time: year Stock X % Stock Y % Market % 2006 14 13 12 2007 19 7 10 2008 -16 -5 -12 2009 3 1 1 2010 20 11 15 Assume that the risk-free rate is 6% and the market risk premium is 5%. What are the betas of Stocks X and y? What are the required rates of return on Stocks X and Y? What is the required rate of return on a portfolio consisting of 80% of Stock X and 20% of Stock Y? If Stock X's expected return is 22%, is Stock X under- or overvalued?
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
You have observed the following returns over time:
| year | Stock X % | Stock Y % | Market % |
| 2006 | 14 | 13 | 12 |
| 2007 | 19 | 7 | 10 |
| 2008 | -16 | -5 | -12 |
| 2009 | 3 | 1 | 1 |
| 2010 | 20 | 11 | 15 |
Assume that the risk-free rate is 6% and the market risk premium is 5%.
- What are the betas of Stocks X and y?
- What are the required
rates of return on Stocks X and Y? - What is the required rate of return on a portfolio consisting of 80% of Stock X and 20% of Stock Y?
- If Stock X's expected return is 22%, is Stock X under- or overvalued?
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