Question

You believe that Alpha stock which has a beta of 1.32 will return 16.0% this coming year. The market is expected to return 11.4% and T-bills return 3.8%. According to CAPM, which one of these statements is correct given this information? Multiple Choice The stock is currently underpriced

The stock plots to the left of the market on a security market line graph The stock plots below the security market line The stock is currently underpriced.

The stock plots to the left of the market on a security market line graph. The stock plots below the security market line O The risk premium on the stock is too low given the stock's beta

Answer 1

> Formula

As per CAPM

Required Return = Risk free rate + ( Market Return - Risk free rate ) * Beta

> Calculation

Required Return = 3.8 + ( 11.4 - 3.8 ) * 1.32

                        = 13.832 %

> Explanation

Exected Return	16.0%
Required return	13.832 %

• If the expected return of the security is less than the return required by CAPM this security would be overvalued and therefore should be sold or an investor should maintain a short position.
• If the expected return is greater than the return required based on the CAPM an investor would then go long the security because the stock expects to return an amount greater than required based on the risk

> Answer

The correct choice is " The stock is currently underpriced "

Hope you understand the solution.