Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.4. The risk-free rate is 0.04 and the market expected rate of return is 0.12. What is the alpha of this security according to the Capital Asset Pricing Model? Please keep at least three decimal places for your answer.

(2.2%)

Explanation:

Ra=?

Rf=4%

Rm=12%

Ba=1.4

Ra=Rf+(Rm-Rf)Ba

Ra=.04+(.12-.04)*1.4

Ra=.04+.112

Ra=15.2%

Alpha of the security=Expected return-CAPM return

                                   =13%-15.2%=(2.2%)

Therefore security is overpriced

Alpha is 2.20%

Explanation:

The formula for Alpha=Actual rate of return-Expected rate of return

Expected rate of return is 0.13 or 13%

Actual rate of return can be deduced from the below formula in Capital Asset Pricing Model

Actual rate of return=Rf+Beta*(Market expected rate of return-Rf)

Beta is 1.4

Rf is the risk free rate of return of 0.04 or 4%

Market expected rate of return  is 0.12 or 12%

Actual rate of return =4%+1.4*(12%-4%)

                                  =4%+(1.4*8%)

                                  =4%+11.2%

                                  =15.2%

Alpha=15.2%-13%=2.20%

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