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CMA Final · Strategic Financial Management · Asset Pricing Theories

Under the Security Market Line, Rf is 7% and the market risk premium is 5%. Stock Ananya Ltd has beta 1.2 and an expected return of 12.5% per analysts. What is its alpha (expected minus required return)?

Alpha is -0.5%. The required return from the SML is 7% plus 1.2 times 5%, which equals 13%. The expected return of 12.5% falls short of this by 0.5%, so the stock plots below the line and is overvalued.

  1. A-0.5%
  2. B0.5%Correct
  3. C1.5%
  4. D-1.5%

Explanation

Required return = 7% + 1.2 x 5% = 13%. Alpha = 12.5% - 13% = -0.5%. Wait: this gives -0.5%, so the stock is overpriced and plots below the SML. Option 0.5% has the wrong sign.

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