An investor buys a stock he determines to be underpriced in the market. He estimates the required return on the stock to be 14%. If he expects that the stock will still be underpriced at the end of the year, the expected holding-period return: A. is equal to 14% B. is greater than 14% C. is less that 14%. D. could be less than, equal to, or greater than 14%. What do you think?

edit: B

D.

D)

I originally put D, but if the stock is underpriced than the holding period return for that year had to be above 14%, right?

Imagine it is underprice by 30%. It could return 20% vs. the 14% required and still be underpriced.

Yes. I would think that the answer is B too. Because that would lead to a positive ex-ante alpha.

I think the issue here is that the holding period is not defined and the stock’s “expected” return should still exceed its required rate of return if is it is still underpriced.

So go with B

mwvt9 Wrote: ------------------------------------------------------- > Imagine it is underprice by 30%. It could return > 20% vs. the 14% required and still be underpriced. But its HPR would still be 20% for that year.

Yeah sorry I didn’t get to finish…had to get the 2 year old. Imagine the return is 1% for the same security. It is still underpriced at the end of the year.

Here is my thinking bud: Normally you would expect the security to have a HPR of greater than 14%, but in the case you expect it to be underpriced at the end of the year. So the question becomes how underpriced to you expect it to be at year end. The question give no clue to this. So say the security is underpriced by 15% and you expect it to be under priced by 0.1% at year end. Your HPR would be 14.9%. If you expect it to be underpriced by 5%, your HPR would be 10% and if you expect it to be underpriced by 1% then HPR is 14%. All that said I could easily be wrong.

I think it’s D. A stock might have a low return next year and then great returns the following years.

Swcheser says it’s D, but explains: “The expected holding-period return (HPR) depends on how underpriced the stock is at the end of the year versus the beginning. The only thing we know for sure is that if the stock is expected to be properly valued at the end of the year HPR>14%.” So, they are wrong with the choice D (it should be “B. is greater than 14%”) but are right with the explanation.

No. They are right. It makes sense. If it were to be PROPERLY valued at year end then HPR>14%. In this case it WON’T be properly valued. It will still be misspriced. See my argument below: So say the security is underpriced by 15% and you expect it to be under priced by 0.1% at year end. Your HPR would be 14.9%. If you expect it to be underpriced by 5%, your HPR would be 10% and if you expect it to be underpriced by 1% then HPR is 14%. *Caps added for emphasis*

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A year is stated in the question.

I agree with mwvts argument, but I think this question is worded awfully.

I do too. I won’t be like this on the real thing. CFAI questions are hard but fair.