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

The risk-free rate is 4% and the market risk premium is 5%. Stock X has a beta of 1.2 and an analyst's forecast expected return of 11%. Relative to the Security Market Line, Stock X's alpha and position are:

Alpha is +1.0% and the stock plots above the SML, so it is undervalued. The CAPM required return is 4% plus 1.2 times 5%, which is 10%. The forecast return of 11% exceeds this by one percentage point, indicating positive alpha.

  1. A+1.0%, plots above the SML (undervalued)Correct
  2. B-1.0%, plots below the SML (overvalued)
  3. C+2.0%, plots above the SML (undervalued)
  4. D+1.0%, plots below the SML (overvalued)

Explanation

Required return = 4% + 1.2 x 5% = 10%. Alpha = 11% - 10% = +1.0%. A positive alpha means the stock offers more than required for its beta, so it plots above the SML and is undervalued. Using 9% (beta x premium, minus the risk-free rate) would wrongly give +2%.

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