CFA Level I · CFA Level I Exam · Portfolio Risk and Return: Part II
An analyst forecasts a return of 11% for a stock with a beta of 0.8. The risk-free rate is 4% and the market risk premium is 7%. Based on the security market line, the stock is most likely:
The stock is undervalued with an alpha of about +1.4%. The SML required return is 4% plus 0.8 times 7%, or 9.6%. The forecast return of 11% exceeds this, so the stock plots above the security market line and offers excess return.
- Aovervalued, with an alpha of about -0.4%
- Bfairly valued, with an alpha of zero
- Cundervalued, with an alpha of about +1.4%Correct
Explanation
Required return = 4% + 0.8 × 7% = 9.6%. Alpha = 11% − 9.6% = +1.4%. The stock plots above the SML, so it is undervalued. The overvalued option comes from a sign error and a wrong required return.
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