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CMA Final · Strategic Financial Management · Asset Pricing Theories

A stock has an expected return of 15% and a beta of 1.2. The risk-free rate is 7% and the market return is 13%. Under the Security Market Line, what is the alpha of the stock and the correct conclusion?

Alpha is +0.8% and the stock is underpriced. The SML required return is 7% plus 1.2 times 6%, which equals 14.2%. The expected return of 15% exceeds this, so the stock lies above the line and offers excess return for its risk.

  1. AAlpha +0.8%; stock is underpricedCorrect
  2. BAlpha -0.8%; stock is overpriced
  3. CAlpha +2.0%; stock is underpriced
  4. DAlpha 0%; stock is fairly priced

Explanation

Required return = 7% + 1.2 x 6% = 14.2%. Alpha = 15% - 14.2% = +0.8%, so the stock plots above the SML and is underpriced. Option +2.0% wrongly compares expected return with the market return of 13%.

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