Turi Teigen, CFA candidate, prepares the following question for her weekly Level 1 study program.
Using the graph (along with the list of assumptions), determine which of the following statements is CORRECT.
Click on the arrows to vote for the correct answer
A. B. C. D.C
Note: RR = required return, ER = expected return.Remember that the SML graph plots systematic, or beta, risk versus expected return. Thus, the numbers on the x-axis represent beta. Using the Capital Asset Pricing Model (CAPM) equation, RR = Rf+ (ERM"" Rf) * Beta = 5.0% + (7.5%) * 0.7 = 10.25%.
Portfolio Y lies below the SML and is thus overvalued and the expected return must be less than the required return. Using the CAPM, RR = Rf+ (ERM"" Rf) * Beta
= 5.0% + (7.5%) * 1.0 = 12.50%. (On the exam, you can quickly determine the RR for a portfolio/asset with a beta of 1.0 by adding the risk-free rate and the market premium.) Since the ER must be less than the RR, the ER must be less than 12.50% and cannot be 15.00%. Since Portfolio Z is on the SML, it is fairly valued and RR = ER. Since Portfolio X lies above the SML, it isundervalued.