If the risk-free rate is 6 percent and the expected rate of return on the marketportfolio is 14 percent, is a security with a beta of 1.25 and an expected rate of return of 16 percent overpriced or underpriced?
To determine if a security is overpriced or underpriced, we can use the Capital Asset Pricing Model (CAPM). The CAPM formula is as follows:
Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)
Let's calculate the expected return using the given information:
Risk-free rate = 6%
Expected market return = 14%
Beta of the security = 1.25
Expected return on the security = 16%
Plug the values into the CAPM formula:
Expected Return = 6% + 1.25 * (14% - 6%)
Expected Return = 6% + 1.25 * 8%
Expected Return = 6% + 10%
So the expected return on the security is 16%, which is higher than the calculated expected return of 16%. Therefore, the security is correctly priced.