Question

If a stock is overpriced relative to its value under the CAPM, where does it plot relative to the Security Market Line (SML)? What is the sign of Jensen’s alpha? Explain in fewer than five sentences.

Answer 1

If a stock is over priced, it will be below the Security market line. Security market line is a plot of stocks with X axis as stocks beta and Y axis as stocks expected return.

If a stock is situated below the security market line, it indicates that for a given risk of beta, the stock is producing only lower returns than predicted by capm. Also the expected return is not able to overcome the inherent risk. Hence this facts will make the share price of the stock to come down until the stocks point reach the security market line.

For such stocks the Jensen alpha will be negative;

alpha = actual return-expected return

Here expected return is the return predicted by capm model and since for over priced stock, the stocks actual return is inferior to predicted return, the alpha will be negative.