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NISM Certifications · NISM-Series-XV: Research Analyst · Fundamentals of Risk and Return

A risk-free asset yields 6%. The market return is 12% and a stock has a beta of 1.5. Under CAPM, the stock's expected return is 15%. If an analyst forecasts a return of 17% for the stock, what is its alpha (forecast minus CAPM return) and the implication?

Alpha is +2% and the stock appears undervalued. CAPM gives a required return of 6 plus 1.5 times 6, which is 15 percent. The forecast of 17 percent exceeds this, so the stock offers excess return for its risk.

  1. AAlpha of +2%; the stock appears undervaluedCorrect
  2. BAlpha of -2%; the stock appears overvalued
  3. CAlpha of +2%; the stock appears overvalued
  4. DAlpha of +5%; the stock appears undervalued

Explanation

CAPM return = 6 + 1.5 x (12 - 6) = 15%. Alpha = 17 - 15 = +2%. A forecast above the required return means the stock offers more than needed for its risk, so it is undervalued. A negative alpha would be the opposite case; +5% wrongly uses a 12% benchmark.

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