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The risk-free rate is 7%. The expected market rate of return is 15%. If you expect a stock with a beta of 1.3 to offer a rate of return of 12%, you should Group of answer choices sell the stock short because it is underpriced. buy the stock because it is underpriced. sell short the stock because it is overpriced. None of the options, as the stock is fairly priced. buy the stock because it is overpriced.

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Answer: Sell short the stock because it is overpriced.

Explanation:

To find out if the stock is overpriced or underpriced, you would need to check to see if the Expected return is indeed 12%.

With the given variables you can do this with the Capital Asset Pricing Model.

The formula is,

Er = Rf + b(Rm + Rf)

Where,

Er is the expected return

Rf is the Risk free rate

b is the Beta

Rm is the Market Rate

Inserting the figures,

= 7% + 1.3(15% - 7%)

= 17.4%

The stock should have an expected return of 17.4% but only has an expected return of 12%. It is underperforming and is therefore OVERPRICED. To benefit from this you should sell the stock short so that when the market prices adjust you can make a profit.

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