You run a regression in which Y = the return on a particular stock, net of the r

Question

You run a regression in which Y = the return on a particular stock, net of the risk-free rate, and X = the return on a market index, net of the risk-free rate. The intercept term in this regression is alpha. Suppose that over a significant period of time a particular stock exhibits a positive alpha, and the alpha estimate is statistically significant. Assuming that the CAPM is true, which statement makes more sense?

A. The stock was generally undervalued during this period

B. The stock was generally overvalued during this period

C. The stock was priced as it should have been in an efficient market

Explanation / Answer

Return on stock - risk free rate=slope*(return on market -risk free rate)+alpha

hence, return on stock=risk free rate + alpha + slope*(return on market -risk free rate)

Comparing with CAPM which says return on stock=risk free rate + slope*(return on market -risk free rate)

So, alpha should be zero but as in our case we see alpha is positive, expected returns is more than required returns hence stock is undervalued..If stock is overvalued , stock generates a return below required return & hence generate negative alpha. However, if stock is undervalued it generates positive alpha.

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