To analyze Stock Y and Stock Z, we first need to understand what beta represents. Beta is a measure of a stock’s volatility in relation to the overall market. A beta above 1 implies greater volatility than the market, while a beta below 1 indicates lower volatility.
For Stock Y, with a beta of 0.80 and an expected return of 16.05%, it is considered less volatile compared to the market. On the other hand, Stock Z has a beta of 0.90 and an expected return of 8%. This suggests that Stock Z has slightly more market risk but offers a lower expected return than Stock Y.
Now let’s evaluate the expected returns in relation to the risk-free rate and market risk premium:
- Risk-Free Rate: 3.0%
- Market Risk Premium: 10%
The expected return can also be assessed using the Capital Asset Pricing Model (CAPM), which is given by:
Expected Return = Risk-Free Rate + Beta * (Market Risk Premium)
Calculating for Stock Y:
- Expected Return (Y) = 3.0% + 0.80 * 10% = 3.0% + 8.0% = 11.0%
Expected Return based on CAPM for Stock Y is 11.0%, but the actual expected return is 16.05%. This indicates that Stock Y is offering a premium over its expected return according to its beta.
Now for Stock Z:
- Expected Return (Z) = 3.0% + 0.90 * 10% = 3.0% + 9.0% = 12.0%
Expected Return based on CAPM for Stock Z is 12.0%, while the actual expected return stands at only 8%. This suggests that Stock Z is not providing a return that compensates for its risk level according to the beta analysis.
In summary, Stock Y is offering a higher return compared to what its beta suggests, implying it may be undervalued or has some other factor supporting its expected return. Conversely, Stock Z appears to underperform relative to its risk profile as indicated by CAPM.