Babu asked in Business & FinanceInvesting · 1 decade ago

How to calculate reward to risk ratio?

stock Y has a beta of 1.5 and an expected return of 17%, stock Z has a beta of 8 and an expected return of 10.5%. If the risk free rate is 5.5% and the market risk premium is 7.5%, are these stocks correctly priced?

Using the information from question 1, what would the risk free rate have to be for the two stocks to be priced correctly?

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  • 1 decade ago
    Favorite Answer

    Solution: We need to calculate the equilibrium rates of return on the two stocks and compare them with the expected rates of return of the respective stocks. A stock would be undervalued if the expected return exceeds the equilibrium rate of return and vice versa. Now, the equilibrium rate of return for a stock is given by the following equation:

    ri=rf+bi(rm-rf) where ri is the equilibrium rate of return on stock 'i', bi is its beta coefficient, rf is the risk-free rate, and rm is the market expected rate of return. Now, the equilibrium rates of return on stocks Y and Z would be as follows:

    ry=.o55+1.5(.13-.055)

    =.055+.1125 = .1675 < exp return of .17; hence, undervalued

    rz=.055+8.0(.13-.055)

    = .055+.600 + .655 > exp return of 10.5, hence, overvalued.

    The rm value in the above equations is the sum of market risk premium and the risk free rate i.e., .o75+.055=.13

    The second part of the question needs a second look by the asker.

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  • nocon
    Lv 4
    3 years ago

    Risk Ratio Formula

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  • Anonymous
    5 years ago

    This Site Might Help You.

    RE:

    How to calculate reward to risk ratio?

    stock Y has a beta of 1.5 and an expected return of 17%, stock Z has a beta of 8 and an expected return of 10.5%. If the risk free rate is 5.5% and the market risk premium is 7.5%, are these stocks correctly priced?

    Using the information from question 1, what would the risk free rate have to be...

    Source(s): calculate reward risk ratio: https://tr.im/ufbkX
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  • Shri
    Lv 4
    4 years ago

    For the best answers, search on this site https://shorturl.im/avgcu

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  • Anonymous
    5 years ago
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