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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Under the CAPM, a security is found to plot above the Security Market Line when its expected return is compared with the return required for its beta. Which statement is correct?

The security is underpriced with a positive alpha, because its expected return exceeds the return required for its beta. Buying pressure should raise its price and lower its expected return until it returns to the Security Market Line.

  1. AThe security is overpriced and its price should be expected to rise
  2. BThe security is underpriced and has a positive alphaCorrect
  3. CThe security has a negative alpha and investors should sell it
  4. DThe security has a beta of zero
  5. The security's total risk is lower than that of the market portfolio

Explanation

A security plotting above the SML offers more expected return than CAPM requires for its systematic risk. Its alpha is therefore positive and it is underpriced. Demand should push its price up and its expected return down until it lies on the SML. The option claiming it is overpriced reverses the sign of alpha.

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