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, the required return for portfolio X = Rf + (ERM – Rf) × Beta = 5.0% + 0.7(7.5%) = 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, required return for portfolio Y = Rf + (ERM – Rf) × Beta = 5.0% + 1.0(7.5%) = 12.50%. (On the exam, you can quickly determine the required return for a portfolio or asset with a beta of 1.0 by adding the risk-free rate and the market premium.) Since the expected return on portfolio Y must be less than the required return, the expected return must be less than 12.50% and cannot be 15%. Since Portfolio Z is on the SML, it is fairly valued and its expected return equals its required return. Since Portfolio X lies above the SML, it is undervalued. |
Using the graph and the list of assumptions, determine which of the following statements is most accurate.