Question

Asset	E(R)	Std. deviation
A	17%	50%
Market (M)	10%	20%

Above is the expected return and standard deviation of a stock A and the market portfolio. The correlation coefficient between A and the market portfolio (M) is 0.5. The risk-free rate is 4%

Based on CAPM, stock A is ____________ because it offers an alpha of ____________.

	A.	underpriced; 7%
	B.	underpriced; 5.5%
	C.	overpriced; 5.5%
	D.	underpriced; 0.5%
	E.	overpriced; -0.5%

Answer 1

Given,
	Return	Standard deviation
A	17%	50%
Market	10%	20%
Risk free rate (Rf)= 4%
Correlation coefficient= 0.5
We know,
Beta= (Correlation coefficient*SD of stock*SD of market)/Variance of market
	(0.5*50*20)/(20)^2
	1.25
As per CAPM,
Re= Rf+(Rm-Rf)*Beta
	4+(10-4)*1.25
	11.50%
Calculation of alpha
Alpha= Expected return-Required return
	17-11.50
	5.50%
As the alpha is positive stock is underpriced.
Based on CAPM, stock A is underpriced because it offers an alpha of 5.50%
Answer: Option B