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CMA Final · Strategic Financial Management · Asset Pricing Theories

A security has an expected return of 15%, beta of 1.2, while Rf is 7% and the market return is 13%. Using the Security Market Line, the security's alpha (expected return minus required return) is:

Alpha is +0.8%. The SML required return is 7% plus 1.2 times 6%, which equals 14.2%. The expected return of 15% exceeds this by 0.8 percentage points, so the security lies above the SML and is undervalued.

  1. A-1.8%
  2. B+0.8%Correct
  3. C+1.0%
  4. D+1.8%

Explanation

Required return = 7% + 1.2 x (13% - 7%) = 7% + 7.2% = 14.2%. Alpha = 15% - 14.2% = +0.8%, so the security plots above the SML and is underpriced. +1.8% results from using 13.2% instead of 14.2%, i.e. a slip in the required return; -1.8% reverses the sign as well.

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