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FRM Part I · FRM Exam Part I · Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

In a market-model regression of a stock's returns on the market's returns, the estimated intercept is 0.5% per month and the beta is 1.1. Which interpretation of the intercept is most appropriate when the regression uses excess returns?

The intercept is Jensen's alpha: the stock's average excess return when the market's excess return is zero. A positive 0.5% monthly alpha means the stock earned more than CAPM predicts for its beta. It does not measure systematic risk, correlation or the risk-free rate.

  1. AIt is the stock's average excess return when the market's excess return is zero, interpreted as Jensen's alphaCorrect
  2. BIt is the stock's systematic risk
  3. CIt is the correlation between the stock and the market
  4. DIt is the risk-free rate per month

Explanation

With excess returns, the intercept is the expected excess return when the market excess return is zero, which is Jensen's alpha. A positive value indicates return above that predicted by CAPM. It is not a risk or correlation measure.

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