You have analyzed the following four securities and have estimated each security's beta and what you expect each security to return next year. The expected return on the market portfolio is 12%, and the relevant risk-free rate is 5%.
-Refer to the information above. Based on your analysis, which of the securities is (are) underpriced?
A)Security A and Security D
B)Security B and Security C
C)Security D
D)Security A

Question

You have analyzed the following four securities and have estimated each security's beta and what you expect each security to return next year. The expected return on the market portfolio is 12%, and the relevant risk-free rate is 5%. 
-Refer to the information above. Based on your analysis, which of the securities is (are) underpriced?
A)Security A and Security D 
B)Security B and Security C 
C)Security D 
D)Security A

Quizplus · Accepted Answer

In order to determine if a security is underpriced or overpriced, we compare its expected return with its required return (based on its beta and the market risk premium). If the expected return is higher than the required return, the security is underpriced and vice versa.

Using the CAPM formula, the required return for each security is:

Security A: 5% + 1.2(12% - 5%) = 14.4%
Expected return for Security A: 14%
Result: Security A is overpriced (expected return < required return)

Security B: 5% + 0.8(12% - 5%) = 9.4%
Expected return for Security B: 8%
Result: Security B is overpriced (expected return < required return)

Security C: 5% + 0.5(12% - 5%) = 8%
Expected return for Security C: 9%
Result: Security C is underpriced (expected return > required return)

Security D: 5% + 1.5(12% - 5%) = 18.5%
Expected return for Security D: 18%
Result: Security D is fairly priced (expected return = required return)

Therefore, only Security C is underpriced, and the answer is C.

You Have Analyzed the Following Four Securities and Have Estimated