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Investment advice and corporate finance
Module 12Investment Management and Corporate FinanceThe risk-free rate is 3%, the market risk premium is 7% and Share K has a beta of 0.8. An analyst forecasts K's return at 10%. What is K's alpha and what does it indicate?
Required return = 3% + 0.8 × 7% = 8.6%. Alpha = forecast − required = 10% − 8.6% = +1.4%, so K plots above the security market line: it offers more than its systematic risk demands, which makes it undervalued. Treating 7% as the market return gives 3% + 0.8 × (7% − 3%) = 6.2% and an alpha of +3.8%. Reversing the subtraction gives −1.4% and the wrong verdict of overvalued. A zero alpha follows only from ignoring beta and comparing 10% with 3% + 7% = 10%. Source: SIDC M12 Study Outline Topic 6.3 Capital Asset Pricing Model; Bodie, Kane and Marcus, Investments, chapter 'The Capital Asset Pricing Model'; CFA Institute, Portfolio Risk and Return: Part II (2026 Level I): E(Ri) = Rf + βi[E(Rm) − Rf] (as at October 2026).
Treating a market risk premium as the market return, which subtracts the risk-free rate a second time.
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