honeycfa

Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X’s beta is 0.9 and Portfolio Y’s beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell:

A) both portfolios X and Y because they are both overvalued.

B) either portfolio X or Y because they are both properly valued.

C) portfolio Y only.

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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.

honeycfa

An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per share over the next year. The company is not expected to pay a dividend. The following information pertains:

• R_F = 8%
• ER_M = 16%
• Beta = 1.7

Should the investor purchase the stock?

A) No, because it is undervalued.

B) No, because it is overvalued.

C) Yes, because it is undervalued.

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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.

aarongreen

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