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Basic Question 4 of 5
Securities A and B have forecasted returns of 14% and 18% over the next 12 months. During the same period, the market (M) is expected to generate returns of 16%. If the risk-free rate is 6% and βA = βB = 1.1, use the CAPM to determine whether the securities are correctly valued.
B. A is overvalued and B is undervalued.
C. B is overvalued and A is undervalued.
D. Both A and B are undervalued.
A. Both A and B are overvalued.
B. A is overvalued and B is undervalued.
C. B is overvalued and A is undervalued.
D. Both A and B are undervalued.
User Contributed Comments 10
| User | Comment |
|---|---|
| zhangjie | Why A is overvalued in the case of 14% less than CAPM 18%? |
| Sandy69 | Security that falls below the SML is overvalued and security that falls above SML is unvealued. Overvalued : sell Undervalued : Buy |
| accounting | take the CAPM ans as the cost and compare that with the return eg. a costs $17 but gives you $14 giving a negative return of -$3 hence overpriced. |
| nsmwaura | Short the overvalued stock and buy the under valued |
| miene | An easy way to remember is the following: Required Rate of Return = Risk Estimated Rate of Return = Reward In our example: For A: Risk (17%) > Reward (14%)-therefore risk outweighs return & stock is overvalued-->SELL For B: Risk (17%) < Reward (18%)-therefore reward outweighs return & stock is undervalued-->BUY |
| BigJimStud | Miene, thats a great way to put it. Thanks so much |
| Juhee | Great job miene |
| bbadger | Beta is the measure of risk related to the market. A beta > 1 means that the stock needs to return greater than the market return to justify the risk. So we immediately know stock A is overvalued (14% return when the market returns 16% and beta of 1.1). Only question is value of B. CAPM with beta = 1.1 gives 17%, meaning the expected return of 18% is better than necessary to justify the risk = undervalued. |
| kingirm | nice explanation miene |
| pigletin | its a math problem slope of the security market line is 16-6= 10 slope of security A and B are 8 and 12 so A is below SML since 8<10, overvalued B is undervalued |
I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!
Barnes
Learning Outcome Statements
describe and demonstrate applications of the CAPM and the SML
CFA® 2025 Level I Curriculum, Volume 2, Module 2.