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.

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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 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

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%.

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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

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.

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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

An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock:

• Market standard deviation = 0.70
• Covariance of Dover with the market = 0.85
• Dover’s current stock price (P₀) = $35.00
• The expected price in one year (P₁) is $39.00
• Expected annual dividend = $1.50
• 3-month Treasury bill yield = 4.50%.
• Historical average S& 500 return = 12.0%.

Dover Holdings stock is:

A) undervalued by approximately 2.1%.

B) undervalued by approximately 1.8%.

C) overvalued by approximately 1.8%.

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To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM).

Step 1: Calculate Expected Return (Holding period return)

The formula for the (one-year) holding period return is:
HPR = (D₁ + S₁ – S₀) / S₀, where D = dividend and S = stock price.
Here, HPR = (1.50 + 39 – 35) / 35 = 15.71%

Step 2: Calculate Required Return

The formula for the required return is from the CAPM: RR = R_f + (ER_M – R_f) × Beta
Here, we are given the information we need except for Beta. Remember that Beta can be calculated with: Beta_stock = [cov_S,M] / [σ²_M]. Here we are given the numerator and the denominator, so the calculation is: 0.85 / 0.70² = 1.73. RR = 4.50% + (12.0 – 4.50%) × 1.73 = 17.48%.

Step 3: Determine over/under valuation

The required return is greater than the expected return, so the security is overvalued.
The amount = 17.48% ? 15.71% = 1.77%.

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.

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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

The expected rate of return is 2.5 times the 12% expected rate of return from the market. What is the beta if the risk-free rate is 6%?

A) 4.

B) 5.

C) 3.

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30 = 6 + β (12 - 6)
24 = 6β
β = 4

honeycfa

Luis Green is an investor who uses the security market line to determine whether securities are properly valued. He is evaluating the stocks of two companies, Mia Shoes and Video Systems. The stock of Mia Shoes is currently trading at $15 per share, and the stock of Video Systems is currently trading at $18 per share. Green expects the prices of both stocks to increase by $2 in a year. Neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the market return is 15% and the risk-free rate is 8%, which trading strategy will Green employ?

Mia Shoes

Video Systems

A) Buy Sell

B) Buy Buy

C) Sell Buy

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The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast return is $2/$15 = 13.3%. The stock is overvalued and the investor should sell it. The required return for Video Systems is 0.08 - 0.3 × (0.15-0.08) = 5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.

honeycfa

Luis Green is an investor who uses the security market line to determine whether securities are properly valued. He is evaluating the stocks of two companies, Mia Shoes and Video Systems. The stock of Mia Shoes is currently trading at $15 per share, and the stock of Video Systems is currently trading at $18 per share. Green expects the prices of both stocks to increase by $2 in a year. Neither company pays dividends. Mia Shoes has a beta of 0.9 and Video Systems has a beta of (-0.30). If the market return is 15% and the risk-free rate is 8%, which trading strategy will Green employ?

Mia Shoes

Video Systems

A) Buy Sell

B) Buy Buy

C) Sell Buy

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The required return for Mia Shoes is 0.08 + 0.9 × (0.15-0.08) = 14.3%. The forecast return is $2/$15 = 13.3%. The stock is overvalued and the investor should sell it. The required return for Video Systems is 0.08 - 0.3 × (0.15-0.08) = 5.9%. The forecast return is $2/$18 = 11.1%. The stock is undervalued and the investor should buy it.

honeycfa

The expected rate of return is 1.5 times the 16% expected rate of return from the market. What is the beta if the risk free rate is 8%?

A) 3.

B) 4.

C) 2.

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24 = 8 + β (16 ? 8)
24 = 8 + 8β
16 = 8β
16 / 8 = β
β = 2

honeycfa

Consider the following graph of the Security Market Line (SML). The letters X, Y, and Z represent risky asset portfolios. The SML crosses the y-axis at the point 0.07. The expected market return equals 13.0%. Note: The graph is NOT drawn to scale.

Using the graph above and the information provided, which of the following statements is most accurate?

A) Portfolio Y is undervalued.

B) The expected return (or holding period return) for Portfolio Z equals 14.8%.

C) Portfolio X's required return is greater than the market expected return.

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At first, it appears that we are not given the information needed to calculate the holding period, or expected return (beginning price, ending price, or annual dividend). However, we are given the information required to calculate the required return (CAPM) and since Portfolio Z is on the SML, we know that the required return (RR) equals the expected return (ER). So, ER = RR = R_f + (ER_M – R_f) × Beta = 7.0% + (13.0% ? 7.0%) × 1.3 = 14.8%.

The SML plots beta (or systematic risk) versus expected return, the CML plots total risk (systematic plus unsystematic risk) versus expected return. Portfolio Y is overvalued – any portfolio located below the SML has an RR > ER and is thus overpriced. Since Portfolio X plots above the SML, it is undervalued and the statement should read, “Portfolio X’s required return is less than the market expected return.”