Problem 2

You learn the following information from a financial analyst who has been following these three stocks:

Table 4.2 Expected Return Beta

Stock Pear 12% 1.5

Stock Banana 8% 1.2

Stock Orange 9% 0.7

You also learn that the risk-free rate is 1%, and the expected market return is 9% per year.

i.Which stock has thehighestrisk? Why?

a.Stock Pear because it has the highest beta;

b.Stock Banana because it has the lowest expected return;

c.Stock Orange because it has the lowest beta;

d.All stocks have the same risk because the idiosyncratic risk is diversifiable.

ii.If the analyst is right, which stock(s) is/are underpriced?

iii.Based on your analysis in (ii), which stock(s) should you buy? Which stock(s) should you sell or short sell?