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# 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 agoFavorite 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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- Anonymous5 years ago
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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...

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