### CFA Practice Question

There are 294 practice questions for this study session.

### CFA Practice Question

Both portfolio Y and Z are well-diversified. The risk-free rate is 6%, the expected return on the market is 15%, and the portfolios have the following characteristics:

Portfolio | Expected Return | Beta
Y | 17% | 1.20
Z | 14% | 1.00

Which of the following best characterizes the valuations of portfolio Y and Z?
A. Y is undervalued and Z is correctly valued.
B. Y is overvalued and Z is correctly valued.
C. Y is undervalued and Z is overvalued.
Explanation: Because both portfolios are completely diversified, their returns should only reflect the systematic risk of the portfolios. Thus, their betas are informative but their deviations are relevant. The required return for each portfolio can be calculated using the CAPM and compared with the associated market-implied expected return.

Y is undervalued. Its CAPM return is 6 + 1.2 x (15 - 6) = 16.8%, yet it has an expected return of 17%. Thus, the portfolio offers more return than is required given its level of risk; it would therefore be attractive to investors. In contrast, Z is overvalued. Its CAPM return is 6 + 1.0 x (15 - 6) = 15%. However, it has an expected return of 14%. Thus, the portfolio offers less return than is required given its level of risk; it would therefore be unattractive to investors.