- CFA Exams
- CFA Exam: Level I 2021
- Study Session 18. Portfolio Management (1)
- Reading 53. Portfolio Risk and Return: Part II
- Subject 4. Applications of the CAPM

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**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.

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.

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.

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**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 |