CA Final · Advanced Financial Management · Security Analysis
A fund manager observes that a share with a beta of 1.2 earned a return of 18% in a year. The risk-free rate was 7% and the market return was 14%. Assuming the CAPM is the correct model of expected return, what is the abnormal return (alpha) on the share, used to judge market efficiency?
The abnormal return is positive 2.6%. CAPM expected return is 7% plus 1.2 times the 7% market premium, which is 15.4%. The actual return of 18% exceeds it by 2.6%. Comparing with the raw market return of 14% would ignore beta risk.
- APositive 2.6%Correct
- BPositive 4.0%
- CNegative 2.6%
- DZero
Explanation
Expected return = 7% + 1.2 × (14% − 7%) = 7% + 8.4% = 15.4%. Abnormal return = 18% − 15.4% = 2.6%. Using the market return of 14% as the benchmark gives 4.0%, ignoring risk adjustment, which is the key error.
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