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) overpriced?
A)Security A only
B)Security B and Security D
C)Security B and Security C
D)Security D only

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) overpriced?
A)Security A only 
B)Security B and Security D 
C)Security B and Security C 
D)Security D only

Quizplus · Accepted Answer

To determine if a security is overpriced, we need to compare its expected return with its required return as determined by the CAPM. The required return can be calculated as the risk-free rate plus the product of the market risk premium and the security's beta.

Using this formula, we can calculate the required return for each security:

Security A: 5% + (12% - 5%) × 0.7 = 10.5%
Security B: 5% + (12% - 5%) × 1.2 = 13.8%
Security C: 5% + (12% - 5%) × 1.8 = 18.9%
Security D: 5% + (12% - 5%) × 0.5 = 8.5%

Comparing the expected returns to the required returns, we find:

Security A: Expected return = 11%, Required return = 10.5%. Security A is not overpriced.
Security B: Expected return = 14%, Required return = 13.8%. Security B is not overpriced.
Security C: Expected return = 19%, Required return = 18.9%. Security C is not overpriced.
Security D: Expected return = 7%, Required return = 8.5%. Security D is underpriced, not overpriced.

Therefore, the securities that are overpriced are none, and the only underpriced security is Security D. Choice C, Security B and Security C, is incorrect.

You Have Analyzed the Following Four Securities and Have Estimated