Question 13.7: An asset is said to be overvalued if its price is too high g...
An asset is said to be overvalued if its price is too high given its expected return and risk. Suppose you observe the following situation:
| Security | Beta | Expected Return |
| SWMS Co. | 1.3 | 14% |
| Insec Co. | .8 | 10 |
The risk-free rate is currently 6 percent. Is one of the two securities overvalued relative to the other?
To answer, we compute the reward-to-risk ratio for both. For SWMS, this ratio is (14% − 6)/ 1.3 = 6.15%. For Insec, this ratio is 5 percent. What we conclude is that Insec offers an insufficient expected return for its level of risk, at least relative to SWMS. Because its expected return is too low, its price is too high. In other words, Insec is overvalued relative to SWMS, and we would expect to see its price fall relative to SWMS’s. Notice that we could also say SWMS is undervalued relative to Insec.