The following data relate to two securities, A and B: A B Expected return 22% 17% Beta factor (β) 1.5 0.7 Assume RF = 10% and RM = 18%. Find out whether the securities, A and B are correctly priced?

If the two securities, A and B are correctly priced then the returns required, based on their levels of systematic risk and calculated from the CAPM, will be the same as their expected returns. The required return can be ascertained with the help of CAPM equation as follows: CAPM Formula: R = R F + β(R M - R F ) R F (Risk-free rate) = 10% = 0.10 R M (Market return) = 18% = 0.18 Security A: Beta (β) = 1.5 Required Return (R A ) = 0.10 + 1.5 * (0.18 - 0.10) R A = 0.10 + 1.5 * 0.08 R A = 0.10 + 0.12 R A = 0.22 or 22% This is equal to the expected return of Security A (22%). Therefore, Security A is correctly priced. Security B: Beta (β) = 0.7 Required Return (R B ) = 0.10 + 0.7 * (0.18 - 0.10) R B = 0.10 + 0.7 * 0.08 R B = 0.10 + 0.056 R B = 0.156 or 15.6% This required return of 15.6% is less than the expected return of 17%. Therefore, Security B is not correctly priced. It is undervalued, giving a return which is higher than what is required based on its level of risk.