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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Introduction to Modern Portfolio Theory

Under CAPM, the risk-free rate is 7% and the expected market return is 13%. Stock X has a beta of 1.5 and an expected return, as forecast by an analyst, of 15%. Which statement is correct?

Stock X is overvalued. CAPM gives a required return of 7% + 1.5 x (13% - 7%) = 16%. The forecast return of 15% is lower than that, so the stock lies below the security market line with negative alpha and offers inadequate compensation for its risk.

  1. AStock X is overvalued because its required return is 16% and the forecast is 15%Correct
  2. BStock X is undervalued because its required return is 16% and the forecast is 15%
  3. CStock X is undervalued because its required return is 14% and the forecast is 15%
  4. DStock X is fairly priced because its required return is 15%

Explanation

Required return = 7 + 1.5x(13-7) = 7 + 9 = 16%. The forecast return of 15% is below the 16% needed for the risk, so alpha is -1% and the stock plots below the security market line, meaning it is overvalued. Using beta times market return (19.5%) or ignoring the premium would mislead.

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