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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 0.8 and an expected return of 7.5%. Which statement is correct?

Stock X plots below the SML with an alpha of −0.5%. The CAPM required return is 4% plus 0.8 times 5%, or 8.0%, which exceeds the 7.5% expected return, so the stock is overpriced and offers less than its required compensation for risk.

  1. AStock X plots above the SML with a positive alpha of 0.5%Correct
  2. BStock X plots on the SML with zero alpha
  3. CStock X plots below the SML with a negative alpha of 0.5%
  4. DStock X plots above the SML with a positive alpha of 3.5%

Explanation

CAPM required return = 4% + 0.8 × 5% = 8.0%. Expected return of 7.5% is below 8.0%, so alpha = 7.5% − 8.0% = −0.5%. Stock X therefore plots below the SML, which is the option stating a negative alpha of 0.5%.

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