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CMA Final · Strategic Financial Management · Asset Pricing Theories

A security has an expected return of 15% and a beta of 1.2. The risk-free rate is 7% and the market return is 13%. What is the security's Jensen alpha, and how is it classified under the Security Market Line?

Alpha is +0.8%, and the security is underpriced. CAPM required return is 7% + 1.2 x 6% = 14.2%, while the expected return is 15%. Since expected exceeds required, the security lies above the Security Market Line and is a buy.

  1. A+0.8%, underpriced, lies above SMLCorrect
  2. B-0.8%, overpriced, lies below SML
  3. C+2.0%, underpriced, lies above SML
  4. D+0.8%, overpriced, lies above SML

Explanation

Required return = 7% + 1.2 x 6% = 14.2%. Alpha = 15% - 14.2% = +0.8%. Positive alpha means the expected return exceeds the required return, so the security plots above the SML and is underpriced. Option +2.0% wrongly compares with 13%, the market return.

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