CFA Practice Question

There are 57 practice questions for this study session.

CFA Practice Question

The market price of a stock is $20 now. The required rate of return is 10%. The intrinsic value, however, should be $22. If the price is going to converge to value in half a year, then the expected rate of return for the period will be approximately:
A. 10%
B. 15%
C. 20%
Explanation: The stock is undervalued by $2, or 10%. The required rate of return for half a year is approximately 5%. The expected rate of return = required return 5% + 10% = 15%.

User Contributed Comments 13

User Comment
pjdeschenes I don't get this. The expected return should just be the ex-ante holding period return: 10%. The question prompt doesn't say anything able annualizing the rate of return.
ljamieson no kidding, I didn't get it either. I think it's that subtle difference between actual return and required return.
fanfanli The security would still be expected to return at least the expected rate of return, ignoring any returns gained from mispricings
aggabad ex ante= expected - required, 10%=expected-5%=>
PRICHARD Can some one explain in a more detailed way? I really dun know wats going on. Thanks.
NillePet expeted return = required return + undervaluation.
reg. return for 6m = 5%
undervaluation = 2/20 = 10%
Thus expected return =15%
LloydBraun7 The stock will converge to value (appreciate 10%) but on top of that will also appreciate by the required rate of return (5% over period).
broadex Expected price= Required rate of return (5%) plus undervaluation (10%)
evanli1 easier way: 20 = 2/ 0.1 (2 =D1)

now Intrinsic 22 = (2 + x) / 0.1
x=> 0.2
0.2/20 is an additional yield of 10% per year/5% semiannual
required return = 10% + additional 5%
Shortseller They assume you get the required half year return ON TOP of the reversion to the intrinsic value.
Shortseller Also technically you would not get 5% you would get 4.8 for the semi annual return.

This is because (1+5%)^2 does not equal 10%.
something2 Good question - un annualize the required rate of return
Amir1 - Exp alpha = Exp return - Required return
- Rearrange: Exp return = Exp alpha + Req return
- Expected return = 2/20 + .10/2 = 15%
(expected alpha or how much it's undervalued is $2 divided by mkt price 20) + (semi-annual required rate of return 10%/2=5%)
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