The following information is available in respect of Security-X and Security-Y: Security b Expected Rate of Return X 1.8 22.00% Y 1.6 20.40% Rate of return of market portfolio is 15.3% If risk free rate of return is 7%,

If the two securities X and Y are correctly priced, then the returns required, based on their levels of systematic risk and calculated from the CAPM, will be the same as their expected returns given. So, the required return can be ascertained with the help of CAPM equation as follows: Security X = I RF + (R M - I RF )b Where I RF = Risk free return b = Beta of security R M = expected return on market index = 7% + (15.3% - 7%) 1.8 = 7% + (8.3%) 1.8 = 7% + 14.94% = 21.94% This is less than expected return of Security X i.e. 22% Therefore security X is not correctly priced. Security Y = I RF + (R M - I RF )b = 7% + (15.3% - 7%) 1.6 = 7% + (8.3%) 1.6 = 7% + 13.28% = 20.28% Return of 20.28% is less than the expected return of 20.40%. Therefore, Security Y is not correctly priced. In case both the securities are correctly priced, then they must offer same reward to risk ratio. The risk free rate would have to be such that (22% - I RF ) ÷ 1.8 = (20.4% - I RF ) ÷ 1.6 (0.22 - I RF ) × 1.6 = (0.204 - I RF ) × 1.8 0.352 - 1.6 I RF = 0.3672 - 1.8 I RF 0.2 I RF = 0.0152 I RF = 0.076 or 7.6% So, both the securities would have correctly priced if the risk free rate is 7.6%.