Question

Suppose the portfolio referenced in problem 8 actually yielded 10%. What would be the Alpha of the portfolio? For your convenience, problem 8 read as follows:

“Suppose the risk-free rate is 1% and the market’s risk premium is 7%. If a portfolio has a Beta of 1.2, what rate of return would you expect on this portfolio?”

Select one:

a. 1.3%

b. .6%

c. .4%

d. -1.3%

Answer 1

The correct answer is b. .6%

• Expected Return is the actual return earned by the stock.
• Required rate of return is the return an investor expects to earn from a stock.

As per Capital Asset Pricing Model (CAPM)

Re = Rf + (Rm-Rf) β

Where Re = Required rate of return

Rf = Risk free rate of return

Rm – Market Return or Expected Return on Market

Rm - Rf = Market risk premium

β – Beta

Rf = 1 %

Rm - Rf = 7%

Beta = 1.2

Re = Rf + (Rm-Rf) β

= 1 + 7 * 1.2

= 1 + 8.4

= 9.4 %

Calculation of Alpha

Alpha = Expected Return - Required rate of return

= 10 % - 9.4%

= 0.6%

Alpha of the stock is 0.6 %