CFA Practice Question

There are 294 practice questions for this study session.

CFA Practice Question

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.

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.
Correct Answer: B

According to the CAPM, a security with a beta of 1.1 has a required return = 6% + 1.1(16% - 6%) or 17%. Therefore, A (expected return = 14%) is overvalued and B (expected return = 18%) is 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
You need to log in first to add your comment.