clearlycanadian

The following information is available for the stock of Park Street Holdings:

• The price today (P0) equals $45.00.
• The expected price in one year (P1) is $55.00.
• The stock's beta is 2.31.
• The firm typically pays no dividend.
• The 3-month Treasury bill is yielding 4.25%.
• The historical average S&P 500 return is 12.5%.

Park Street Holdings stock is:

A) overvalued by 1.1%.

B) undervalued by 3.7%.

C) undervalued by 1.1%.

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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 = (0 + 55 – 45) / 45 = 22.2%

Step 2: Calculate Required Return:
The formula for the required return is from the CAPM:

RR = Rf + (ERM – Rf) × Beta
RR = 4.25% + (12.5 – 4.25%) × 2.31 = 23.3%.

Step 3: Determine over/under valuation:

The required return is greater than the expected return, so the security is overvalued.
The amount = 23.3% − 22.2% = 1.1%.

clearlycanadian

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.

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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.

clearlycanadian

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).

clearlycanadian

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).

clearlycanadian

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&P 500 return = 12.0%.

Dover Holdings stock is:

A) overvalued by approximately 1.8%.

B) undervalued by approximately 2.1%.

C) undervalued 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 = Rf + (ERM – Rf) × Beta
Here, we are given the information we need except for Beta. Remember that Beta can be calculated with: Betastock = [covS,M] / [σ2M]. 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%.

clearlycanadian

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) Sell Buy

C) Buy 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.

clearlycanadian

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

B) Portfolio Y is undervalued.

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 = Rf + (ERM – Rf) × 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.”

clearlycanadian

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) portfolio Y only.

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

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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.

clearlycanadian

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:

• RF = 8%
• ERM = 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.

clearlycanadian

A stock's abnormal rate of return is defined as the:

A) rate of return during abnormal price movements.

B) actual rate of return less the expected risk-adjusted rate of return.

C) expected risk-adjusted rate of return minus the market rate of return.

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Abnormal return = Actual return – expected risk-adjusted return