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

Stock A has an expected return of 14%, a standard deviation of 20% and a beta of 1.2. The risk-free rate is 6%, and the market return is 11%. Using the CAPM, and the Sharpe ratio for stock A, which statement is correct?

Required return under CAPM is 12%, from 6% plus 1.2 times the 5% market premium. Since expected return of 14% exceeds it, the stock is undervalued. The Sharpe ratio is (14-6)/20, which equals 0.40.

  1. ARequired return is 12%; stock A is undervalued with a Sharpe ratio of 0.40Correct
  2. BRequired return is 12%; stock A is overvalued with a Sharpe ratio of 0.70
  3. CRequired return is 11%; stock A is undervalued with a Sharpe ratio of 0.40
  4. DRequired return is 17.2%; stock A is overvalued with a Sharpe ratio of 0.40

Explanation

CAPM required return = 6 + 1.2×(11-6) = 12%. Expected 14% exceeds 12%, so the stock plots above the security market line and is undervalued. Sharpe = (14-6)/20 = 0.40. The 0.70 option wrongly divides by the beta-based figure; 17.2% uses market return instead of the premium.

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