You are evaluating two stocks A and B. Their historical 3-year performance has been a return of

QUESTION

You are evaluating two stocks, A and B. Their historical 3-year performance has been a return of E[r(A)] = 11% and E[r(B)] = 13%, with standard deviations (A) = 16% and (B) = 23%. The market has returned E[r(M)] = 12% with a standard deviation of the market of (M) = 20%. You estimate the covariance of A with the market as Cov(r(A),r(M)) = 0.033 and Cov(r(B),r(M)) = 0.05. The risk-free rate is 5%. Which of the following are true?I. A is undervalued and B is overvalued.II. Both A and B are undervalued.III. Buying B and shorting A is an arbitrage.IV. You should buy both A and B.A. I OnlyB. II OnlyC. II and III onlyD. II, III and IV onlyE. III and IV only.
Answer: A: Based on below A is undervalued and B is overvalued, thus you would want to buy A and short sell B (which is not an option) Beta A = 0.033 / (.2^2) = 0.825 Beta B = 0.05 / ((.2^2) = 1.25 Reward to Risk (A) = (.11-.05) / 0.825=.0727,

rvalued Reward to Risk (B) = (.13-.05) / 1.25 = .064, Overvalued Reward to Risk (Market) = (.12-.05) / 1 = 0.07, used to determine if A and B are under or overvalued

ANSWER:

CLICK REQUEST FOR  AN EXPERT SOLUTION