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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

A security has beta 1.2. The risk-free rate is 6% p.a. and the expected market return is 12% p.a. Observed average return on the security is 14.0% p.a. Under the CAPM, the security's alpha (actual minus required return) is:

The CAPM required return is 6% plus 1.2 times the 6% market premium, which equals 13.2%. The observed return of 14.0% exceeds this by 0.8%, so the alpha is positive 0.8% per annum.

  1. A+0.8%Correct
  2. B-0.8%
  3. C+2.0%
  4. D+1.2%
  5. 0.0%

Explanation

Required return = 6% + 1.2 x (12% - 6%) = 6% + 7.2% = 13.2%. Alpha = 14.0% - 13.2% = +0.8%. Using 12% as the required return, i.e. ignoring beta, gives +2.0%, which is wrong.

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