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

A share has a current price of Rs 200 and is expected to be worth Rs 226 in one year, with no dividend. The risk-free rate is 5% and the market risk premium is 7%. The share's beta is 0.8. Relative to the Security Market Line, the share is:

The share is underpriced with alpha of 2.4%. Its expected return is 26/200 = 13%, while CAPM requires 5% + 0.8×7% = 10.6%. Since expected return exceeds the required return, it plots above the Security Market Line.

  1. AOverpriced, plotting below the SML, since its expected return of 13% exceeds the required return
  2. BFairly priced, plotting on the SML
  3. CUnderpriced, plotting above the SML, with alpha of 2.4%Correct
  4. DUnderpriced, plotting above the SML, with alpha of 7.4%
  5. Overpriced, plotting below the SML, with alpha of −2.4%

Explanation

Expected return = 26/200 = 13%. Required return = 5% + 0.8 × 7% = 10.6%. Alpha = 13% − 10.6% = 2.4%, positive, so the share plots above the SML and is underpriced. Option D uses 13% − 5.6% by subtracting only the premium component incorrectly.

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