Portfolio X’s required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess return of 1.7%

Portfolio Y’s required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess return of 1.3%.

Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its excess return is less than that of Portfolio X.

In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return.

Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows/dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta * (expected market rate - risk free rate).

ER = (26 ? 20) / 20 = 0.30 or 30%, RR = 8 + (16 ? 8) × 1.7 = 21.6%. The stock is underpriced therefore purchase.