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NISM Certifications · NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Investing in Stocks (NISM XXI-A)

A stock has a beta of 1.2, the risk-free rate is 7% and the expected market return is 12%. Using the Capital Asset Pricing Model, what is the required return on the stock, and what happens if its expected return is 12.5%?

The CAPM required return is 13%, calculated as 7% plus 1.2 times the 5% market risk premium. Since the expected return of 12.5% is lower than 13%, the stock offers too little for its risk and is overvalued.

  1. A13%; the stock is overvalued as expected return exceeds required return
  2. B13%; the stock is undervalued as required return exceeds expected return
  3. C13%; the stock is fairly priced
  4. D13%; the stock is overvalued as expected return is below required returnCorrect

Explanation

Required return = 7% + 1.2 x (12% - 7%) = 7% + 6% = 13%. The expected return of 12.5% is below the required 13%, so the stock lies below the security market line and is overvalued. Options claiming undervaluation or fair pricing, or giving the wrong reasoning, contradict this.

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