7.2. The risk-free rate of return is 5%, the return of the market is 11.2%, beta is 1.8, and the actual return of a stock is 14%. Find the expected return and alpha of the stock. Is the stock fairly valued, undervalued, or overvalued? E(r) = q = OVER FAIR UNDER
Expert Answer
Rf = 5%
Beta = 1.8
Market rate = Rm = 11.2%
Expected return= Re= Rf + Beta(Rm-Rf)
= 5 + 1.8*(11.2-5)
= 16.16%
Actual Return = 14%
Alpha = Actual return – expected return = 14 – 16.16 = -2.16%
As the alpha is negative stock is overpriced.