### CFA Practice Question

Given that the risk-free rate of return is 5.4%, return on the market portfolio is 13%, the standard deviation for returns for the market portfolio is 14, the covariance of a stock with the market portfolio is 214, and the expected rate of return for the stock is 14.1%, is the stock overvalued, undervalued, or correctly valued?
A. Overvalued
B. Correctly valued
C. Undervalued
Explanation: The CAPM asserts that the following equation holds: the required rate of return on a security is equal to the risk-free rate plus the beta multiplied by the market risk premium on that stock. The beta is equal to the covariance of that security with the market, divided by the square of the standard deviation of the market 214 / 142 = 1.0918. The required rate of return on the stock in this question is 5.4 +(1.0918) x (13 - 5.4) = 13.7%. Because the stock is expected to provide rates of return greater than investors would require based on its systematic risk (14.1% versus 13.7%), it is undervalued.