honeycfa

If a stock is located above the security market line (SML), an investor would consider the stock to be:

A) efficiently priced but the market is not.

B) overvalued, with too much risk for its expected return.

C) undervalued, with less risk then expected for its expected return.

---

The SML plots required return for level of systematic risk (beta). A security priced above the SML has an expected return greater than that required by its level of systematic risk.

honeycfa

Consider a stock selling for $23 that is expected to increase in price to $27 by the end of the year and pay a $0.50 dividend. If the risk-free rate is 4%, the expected return on the market is 8.5%, and the stock’s beta is 1.9, what is the current valuation of the stock? The stock:

A) is undervalued.

B) is correctly valued.

C) is overvalued.

---

The required return based on systematic risk is computed as: ER_stock = R_f + (ER_M – R_f) × Beta_stock, or 0.04 + (0.085 – 0.04) × 1.9 = 0.1255, or 12.6%. The expected return is computed as: (P₁ – P₀ + D₁) / P₀, or ($27 – $23 + $0.50) / $23 = 0.1957, or 19.6%. The stock is above the security market line ER > RR, so it is undervalued.

honeycfa

If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock?

A) 7.8%.

B) 12.4%.

C) 11.3%.

---

The formula for the required return is: ER_stock = R_f + (E_RM – R_f) × Beta_stock,
or 0.035 + (0.095 – 0.035) × 1.3 = 0.113, or 11.3%.

honeycfa

Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.

Snow places:

A) only Cubb on the list.

B) neither security on the list.

C) only Bahre on the list.

---

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 flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate).

• For Bahre: ER =  10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list.
• For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager). 

honeycfa

What is the expected rate of return on a stock that has a beta of 1.4 if the market risk premium is 9% and the risk-free rate is 4%?

A) 13.0%.

B) 11.0%.

C) 16.6%.

---

Using the security market line (SML) equation:

4% + 1.4(9%) = 16.6%.

honeycfa

A stock that plots below the Security Market Line most likely:

A) has a beta less than one.

B) is overvalued.

C) is below the efficient frontier.

---

Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or mathematically.  Your answers will always be the same.

Graphically: If you plot a stock’s expected return on the SML and it falls below the line, it indicates that the stock is currently overpriced, causing its expected return to be too low.  If the plot is above the line, it indicates that the stock is underpriced.  If the plot falls on the SML, it indicates the stock is properly priced. 

Mathematically: 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.

honeycfa

The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return is 5%, what is the expected return of the market?

A) -1.0%.

B) +3.0%.

C) +3.5%.

---

RR_Stock = R_f + (R_Market ? R_f) × Beta_Stock, where RR = required return, R = return, and R_f = risk-free rate

A bit of algebraic manipulation results in:

R_Market = [RR_Stock ? R_f ? (Beta_Stock × R_f)] / Beta_Stock = [8 ? 5 ? (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1%

honeycfa

When the market is in equilibrium:

A) all assets plot on the SML.

B) all assets plot on the CML.

C) investors own 100% of the market portfolio.

---

When the market is in equilibrium, expected returns equal required returns. Since this means that all assets are correctly priced, all assets plot on the SML.

By definition, all stocks and portfolios other than the market portfolio fall below the CML. (Only the market portfolio is efficient.

honeycfa

What is the required rate of return for a stock with a beta of 1.2, when the risk-free rate is 6% and the market is offering 12%?

A) 7.2%.

B) 13.2%.

C) 6.0%.

---

RR_Stock = R_f + (R_Market - R_f) × Beta_Stock, where RR= required return, R = return, and R_f = risk-free rate. 

Here, RR_Stock = 6 + (12 - 6) × 1.2 = 6 + 7.2 = 13.2%.

honeycfa

The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A?

A) 13.8%.

B) 14.2%.

C) 15.6%.

---

RR_Stock = R_f + (R_Market - R_f) × Beta_Stock, where RR= required return, R = return, and R_f = risk-free rate

Here, RR_Stock = 6 + (12 - 6) × 1.3  = 6 + 7.8 = 13.8%.