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CFA Level I · CFA Level I Exam · Portfolio Risk and Return: Part II

A stock has a beta of 0.8 and an expected return of 8.0%. The risk-free rate is 2% and the expected market return is 8%. The stock's alpha and the most appropriate action are closest to:

Alpha is about +1.2%, so buying is appropriate. CAPM required return is 2% plus 0.8 times the 6% market premium, or 6.8%. The expected return of 8.0% exceeds this by 1.2%, so the stock plots above the SML and is undervalued.

  1. Aalpha of +1.2%; buy the stock as it is undervaluedCorrect
  2. Balpha of 0.0%; hold the stock as it is fairly priced
  3. Calpha of −1.2%; sell the stock as it is overvalued

Explanation

Required return = 2% + 0.8 × 6% = 6.8%. Alpha = 8.0% − 6.8% = +1.2%. The stock offers more than required, so it is undervalued; a negative alpha would come from subtracting in the wrong order.

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