CFA Practice Question

CFA Practice Question

The beta of a security is 1.15 with the risk-free rate at 4%. If the market risk premium is 3.5%, what action should an investor take if the security is priced at a rate of return of 9%?
A. Buy the security
B. Sell or short-sell the security
C. Buy the risky market portfolio and borrow against the risk-free security
Explanation: The security is underpriced on the basis of the security market line. Its required rate of return = 4.0 + 1.15 x 3.5 = 8.03% < 9.0%. The market requires 8.03% return; the security is offering a higher return, i.e., 9.0%. Thus, investors should buy it, as this is an arbitrage opportunity.

User Contributed Comments 3

User Comment
george2006 if a stock is priced at higher rate of return than its intrinsic rate of return then it is underpriced.
goalrush why is c wrong? That is arbitrage too ( more so as it doesn't cost anything)
dcorona19 yeah well the free risk still costs you something
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