If the risk-free rate is 6 percent and the expected rate of return on the market portfolio 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 whether a security is overpriced or underpriced, we can use the Capital Asset Pricing Model (CAPM). The CAPM formula is:
Expected return = Risk-free rate + (Beta * (Expected market return - Risk-free rate))
Given the following information:
Risk-free rate = 6%
Expected market return = 14%
Beta = 1.25
Expected rate of return = 16%
We can plug these values into the CAPM formula and calculate the expected return:
Expected return = 6% + (1.25 * (14% - 6%))
Expected return = 6% + (1.25 * 8%)
Expected return = 6% + 10%
Based on the calculation, the expected return for the security is 16%, which matches the expected rate of return given in the question. This means that the security is priced correctly according to the CAPM. Neither overpriced nor underpriced.