Undervalued security
Under CAPM, a security whose estimated return plots above the Security Market Line — earning more than its systematic risk (beta) warrants under market equilibrium.
In plain language
The Security Market Line shows the return every security should earn for its level of market risk. Real securities do not always sit exactly on that line.
When a security's actual estimated return is higher than the SML says it should be for that security's beta, the security is undervalued — the market has not yet priced it correctly, and its price should rise as the market corrects the mispricing.
A security plotting below the SML is the opposite case: overvalued, earning less than its risk warrants.
How it works
The workbook's own worked example (section 16.9): with beta 1.2, risk-free rate 8%, and market risk premium (Rm − Rf) 14%, the CAPM-required return is:
8% + (1.2 × 14%) = 24.8%
If the stock is currently expecting to generate 26% — above the 24.8% the SML says it should earn for that beta — it is plotting above the SML, and the workbook calls it undervalued. The workbook's Exhibit 16.6 shows this graphically: security C, above the SML, is undervalued because it has a higher expected return than its market risk warrants; security D, below the SML, is overvalued for the opposite reason.
A worked example
Following the workbook's own SML figures. A logistics stock has a beta of 1.2. The risk-free rate is 8% and the market risk premium is 14%, so its CAPM-required return is 8% + (1.2 × 14%) = 24.8%.
An analyst estimates the stock will actually deliver 26%, based on its current price and expected earnings. Since 26% is above the 24.8% the SML demands for beta 1.2, the stock is undervalued.
On a Rs 20,00,000 position, if the market corrects this mispricing by bringing the stock's return down toward its SML-implied 24.8% through a price increase, the investor captures the gap between the two returns as extra gain, on top of the 24.8% the security was already fairly owed for its risk.
Why NISM asks about it
Chapter 16 (Introduction to Capital Market Theory), section 16.9 (Security Market Line), derives undervalued and overvalued security directly from a security's position relative to the SML, using the beta 1.2 / 24.8% / 26% example. Expect a question computing the SML-required return for a given beta and comparing it to a stated estimated return.
Common exam traps
- Above the SML = undervalued (higher return than the risk warrants); below the SML = overvalued — this is the opposite of how 'overvalued' sounds intuitively to some candidates, since it refers to return, not price level directly.
- The comparison is between the security's estimated return and its CAPM-required return for its own beta — not between its return and the market return.
- Under CAPM's equilibrium assumption, all securities should plot exactly on the SML — an undervalued or overvalued security is, by definition, a temporary deviation from that equilibrium.
- Do not confuse this SML-based mispricing test with the workbook's separate, ratio-based value stock classification (low P/E, low P/B, high dividend yield) — the two are different tests for different purposes, from different chapters.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Market anomalyA pattern of returns that departs from what an asset's fundamentals and risk — as measured by CAPM or another pricing model — say it should earn, and so contradicts market efficiency.
- Value stockA stock classified, typically for index and benchmarking purposes, as cheap relative to its fundamentals — low price-to-book, low price-to-earnings and high dividend yield being the workbook's own ratio criteria.