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CFA Level I · CFA Level I Exam · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models

An analyst estimates a stock's expected return at 11.0%. The risk-free rate is 4.0%, the market risk premium is 5.0%, and the stock's beta is 1.2. Relative to the security market line, the stock is most likely:

The stock is undervalued and plots above the security market line. Its CAPM required return is 10.0% (4% plus 1.2 times 5%), while the analyst expects 11.0%. The positive 1.0% difference means investors earn more than compensation for the stock's systematic risk.

  1. Aundervalued, plotting above the lineCorrect
  2. Bfairly valued, plotting on the line
  3. Covervalued, plotting above the line

Explanation

Required return = 4.0% + 1.2 × 5.0% = 10.0%. The expected return of 11.0% exceeds the required return by 1.0%, a positive alpha. A stock plotting above the SML offers more return than required for its risk, so it is undervalued.

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