Question

According to the CAPM, a security is considered underpriced when its expected return plots ___ the SML.

a) Below
b) On
c) Above
d) Parallel to

Answer 1

c) Above

A security is considered underpriced according to CAPM when its expected return is above the SML, indicating a higher return for its level of risk than the market average.

Step-by-step explanation:

According to the Capital Asset Pricing Model (CAPM), a security is considered underpriced when its expected return plots above the Security Market Line (SML). The SML represents the expected return of a security based on its systematic risk as measured by its beta. If a security's expected return is above the SML, it indicates that the security is providing a higher return for its level of risk than the market average, which implies that it may be a good investment opportunity as it is not adequately priced by the market.