hey everyone, i dont get the topic on mispricing of securities, can anyone help me out? It says if estimated return plots over the SML, the security is undervalued and vice versa. I am not able to relate this. Please explain this.
If the security plots above the SML, then its expected return is higher than is appropriate for its level of risk.
Think of it this way: the security is priced at $10/share, and the expected return is $1/share: 10%. According to the SML, the return (for its level of risk) should be 5%. A $1 return is 5% of $20, so the security should be priced at $20/share, not $10/share: it’s underpriced.
thank you Sir.
i am confused now.
Either way, it’s underpriced.
You and I are saying (essentially) the same thing, but from different viewpoints. I’m saying that the return will be X, solve for the price. You’re saying that the (new) price will be Y, solve for the (current) price. Note that in your solution the return is not $1 (which I stipulated); it’s $0.53.
Yes, If security plots above the SML it means it is giving more return on the same level of risk. So we can say it security is underpriced.
And if security is plots below SML means it is giving less return on same level of risk. So we can say it is overvalued.