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NISM Certifications · NISM-Series-XV: Research Analyst · Fundamentals of Risk and Return

A stock has beta of 1.2. The risk-free rate is 7% and the expected market return is 12%. Using CAPM, the stock's required return is 13%. An analyst forecasts the stock will return 12.5%. Which conclusion is correct?

CAPM gives a required return of 7 plus 1.2 times 5, which is 13 percent. The forecast of 12.5 percent is lower, giving a negative alpha of 0.5 percent. The stock plots below the security market line, so it is overvalued.

  1. AThe stock is undervalued because forecast return is below the required return
  2. BThe stock is overvalued because it plots below the security market line, with an alpha of -0.5%Correct
  3. CThe stock is undervalued because its alpha is +0.5%
  4. DThe stock is fairly priced because forecast return is close to the market return of 12%

Explanation

Required return = 7 + 1.2 x (12 - 7) = 7 + 6 = 13%. Forecast 12.5% minus 13% gives alpha of -0.5%, so the stock lies below the SML and is overvalued. Options A and C misread the sign or the implication, and D compares with the market return instead of the beta-adjusted requirement.

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