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CMA Final · Strategic Financial Management · Asset Pricing Theories

A share has an expected return of 14% and a beta of 1.2. The risk-free rate is 7% and the market return is 13%. What is the share's alpha, and how is it classified under the Security Market Line?

Alpha is minus 0.2%, and the share is overpriced. CAPM required return is 7% plus 1.2 times 6%, which is 14.2%. The expected return of 14% falls short of this, so the share plots below the Security Market Line.

  1. AAlpha of -0.2%; overpriced, plots below the SML
  2. BAlpha of +0.2%; underpriced, plots above the SMLCorrect
  3. CAlpha of +1.0%; underpriced, plots above the SML
  4. DAlpha of -1.0%; overpriced, plots below the SML

Explanation

Required return = 7 + 1.2 x (13 - 7) = 7 + 7.2 = 14.2%. Alpha = expected minus required = 14 - 14.2 = -0.2%. Hence the share plots below the SML and is overpriced. The figure +0.2% with underpriced has the sign reversed.

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