Jenny has $200,000 to invest and is considering the merits of two securities. He is interested in the common shares of X Co. and Y Inc. The possible monthly rate of return of the securities is shown below: Possible Monthly Rate of Return of Security in January 2019 Probability State of Affair Stock X Stock Y Boom 0.2 50% -5% Normal 0.5 15% 8% Recession 0.3 -5% 10%
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
(d) Suppose the risk-free rate is 4%, the market risk premium is 15% and the betas for stocks X and Y are 1.2 and 0.2 respectively. Using the
(e) Given the results above, are Stocks X and Y overpriced or underpriced? Explain.
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