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CMA Final · Strategic Financial Management · Asset Pricing Theories

A stock has an expected return of 14% and a beta of 1.2. The risk-free rate is 5% and the market risk premium is 7%. What is the stock's Jensen alpha, and how is it classified under the Security Market Line?

Alpha is +0.6%. The CAPM required return is 13.4% (5% plus 1.2 times 7%), while the expected return is 14%. Since expected exceeds required, the stock plots above the Security Market Line and is regarded as underpriced.

  1. AAlpha of +0.6%; the stock plots above the SML and is underpricedCorrect
  2. BAlpha of -0.6%; the stock plots below the SML and is overpriced
  3. CAlpha of +0.6%; the stock plots below the SML and is overpriced
  4. DAlpha of +3.4%; the stock plots above the SML and is underpriced

Explanation

Required return = 5% + 1.2 x 7% = 13.4%. Alpha = 14% - 13.4% = +0.6%. A positive alpha means the stock lies above the SML, so it is underpriced. The +3.4% option wrongly uses 1.2 x 7% as if it were the required total return less... it ignores the risk-free rate, so it is wrong.

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