Answer: Above the SML

## Explanation Undervalued stocks plot **above** the Security Market Line (SML). Here's why: ### Understanding the Security Market Line (SML) - The SML is a graphical representation of the Capital Asset Pricing Model (CAPM) - It plots expected return against systematic risk (beta) - The line represents the equilibrium condition where all securities are fairly priced ### Why Undervalued Stocks Plot Above the SML - Stocks that plot **above** the SML offer higher returns than what the CAPM would predict given their level of risk - This indicates they are providing more return for their risk level than what is considered fair or average - These stocks are attractive investments because they offer superior risk-adjusted returns ### Why Other Options Are Incorrect - **Option B (Under the SML)**: Stocks below the SML are **overvalued** - they offer lower returns than expected for their risk level - **Option C (Always on the SML)**: While the SML represents equilibrium, real-world market imperfections mean stocks can deviate from it - **Option D (Valuation cannot be determined)**: The SML is specifically designed to help determine valuation by comparing actual vs. expected returns ### Key Takeaways - **Above SML** = Undervalued (good investment opportunity) - **Below SML** = Overvalued (poor investment opportunity) - **On SML** = Fairly valued (expected return matches risk level)

Author: Tanishq Prabhu