We can use the security market line (SML) to estimate the required return or beta on the various securities, and compare this with the expected returns.
The SML looks like this: E(r) = Rrf + β (RPM).
Since Montana’s beta is 1.50: 7.0 + 1.50(7.0) = 17.5% = the required return. Because Montana’s expected return is 15%, and the required return is 17.5%, Montana should not be purchased. Note that this is true even though Montana’s expected return is more than the other stocks and the market: it is not enough to compensate for the level of market risk assumed by holding the stock.
Texas’ required return = 11.0 = 7.0 + β(7.0), so β = (4/7) = 0.57. However, its expected return is less than the required return, so regardless of the beta value, Texas should not be purchased.
Ohio’s required return is given as 10.5, and the expected return is 12.0. Hence, Ohio is a buy
