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SML Expected VS Required return

a.bologna295

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Thread starter #1
Hi @David Harper CFA FRM ,

I hope you are doing well.

I found a tricky question in other materials (than BT) and I found this question:

An analyst gathered the following data about three stocks:
Stock; Beta; Estimated Return
A; 1.5; 15.0%
B; 1.1; 15.7%
C; 0.6; 14.2%

If the risk-free rate is 8% and the risk-premium on the market is 7%, are Stock A and Stock C undervalued, properly
valued, or overvalued, according to the security market line (SML)?

Stock A; Stock C;
A) Undervalued Undervalued
B) Overvalued Overvalued
C) Undervalued Overvalued
D) Overvalued Undervalued

The answer seems to be D but I have calculated C.

Could you please help me on this?
How would you proceed?

Adele
 

David Harper CFA FRM

David Harper CFA FRM (test)
Staff member
#2
Hi Adele (@a.bologna295 ) this is a typical pattern-like question in the CAPM cluster. The CAPM tells us that we might expect all securities (in the world where systematic risk is the only factor) to plot on the SML; under-valued (over-valued) securities will plot above (below) the SML. Consquently, this problem reduces to solving for the (Jensen's = CAPM world) alpha:
  • Stock A's alpha = 15.0% - (1.5 β * 7% MPR + 8.0%) = -3.5%; ie., actual E(r) plots below SML, so overpriced
  • Stock C's alpha = 14.2% - (0.6 β * 7% MPR + 8.0%) = +3.5%; ie., actual E(r) plots above SML, so underpriced. Thanks,
 
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