Question

consider two stocks a and b stock a has an expted return of 10% and a beta of 1.2. stock b has an expected return of 14% and a beta of 1.8. teh expected market rate return is 9% and the risk free rate is 5% security would be considered the better buy because

Answer 1

Answer: Stock B as it offers an excess of 1.8%

Explanation:

The better security to buy would be the one that is offering a return higher than what it is supposed to be according to the Capital Asset Pricing Model.

Expected return = Risk-free rate + beta * (Market return - risk free rate)

Stock A

= 5% + 1.2 * (9% - 5%)

= 9.8%

Stock A is meant to be offering 9.8% yet it is offering 10%. The excess return therefore is;

= 10% - 9.8%

= 0.2%

Stock B

= 5% + 1.8 * ( 9% - 5%)

= 12.2%

Stock B is meant to be offering 12.2% yet it is offering 14%. The excess return therefore is;

= 14 - 12.2

= 1.8%

Stock B is therefore the better option.