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CMA Final · Strategic Financial Management · Asset Pricing Theories

Stock Arjun Ltd has an expected return of 15%, a beta of 1.2, the risk-free rate is 7% and the market return is 13%. What is its Jensen alpha, and how is the stock placed relative to the Security Market Line?

Alpha is +0.8% and the stock is underpriced, plotting above the SML. The required return is 7% plus 1.2 times 6%, which is 14.2%. Since the expected return of 15% exceeds this, the excess of 0.8% is positive alpha.

  1. AAlpha of +0.8%; stock plots above the SML (underpriced)Correct
  2. BAlpha of -0.8%; stock plots below the SML (overpriced)
  3. CAlpha of +2.0%; stock plots above the SML (underpriced)
  4. DAlpha of +0.8%; stock plots below the SML (overpriced)

Explanation

Required return = 7% + 1.2 x (13% - 7%) = 7% + 7.2% = 14.2%. Alpha = 15% - 14.2% = +0.8%. Positive alpha means the expected return exceeds the required return, so the stock lies above the SML and is underpriced. Alpha of 2.0% would arise from comparing 15% with 13%, the market return, ignoring beta.

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