# overvalued / undervalued / properly valued

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 percent and Portfolio Y to return 14 percent 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 percent, and the risk-free rate is 5 percent. Smith should sell: A) portfolio X only. B) portfolio Y only. C) both portfolios X and Y because they are both overvalued. D) either portfolio X or Y because they are both properly valued.

SML port X: 5+0.9(12-5)= 11.3 SML port y: 5+1.1(12-5)= 12.7 expected return x: 13 expected return y: 14 ergo: C - both are overvalued

both seem to be undervalued according to CAPM( 11.3 and 12.7 respectively).since X is less undervalued,it could be sold answer A

Agree with A for same reason Dsylexic stated.

The correct answer was B) portfolio Y only. 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.

argh…ofcourse. somehow i calculated 12-11.3 .careless mistakes. sigh

I got B but did is a a ratio expected return/required return port X had a higher figure

barthezz Wrote: ------------------------------------------------------- > SML port X: 5+0.9(12-5)= 11.3 > SML port y: 5+1.1(12-5)= 12.7 > > expected return x: 13 > expected return y: 14 > > ergo: > > C - both are overvalued yeah indeed - if above the sml the portfolios are undervalued. my bad - need to pay more attention

These are what I mean about tricky questions. (see my other post: “How Tricky Are the Distractors…”) If there was an answer that said “keep both because they are undervalued”, I would have gotten it wrong. Because that answer wasn’t there, I had to reread the problem which said he had to sell AT LEAST 1…