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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 passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
Tamara Schultz
Learning Outcome Statements
describe and demonstrate applications of the CAPM and the SML
CFA® 2024 Level I Curriculum, Volume 2, Module 2.