Archive / Investment Adviser (Level 1) / Introduction to Modern Portfolio Theory

nism-series-xa-security-market-line-negative-alpha-overvalued[ INVESTMENT ADVISER (LEVEL 1) ]

On the Security Market Line (SML) diagram, where does an 'Overvalued' stock with negative Jensen's Alpha plot?

[ A ]BELOW the Security Market Line (providing an expected return lower than the fair CAPM required return for its systematic Beta risk).[ CORRECT ]

[ B ]ABOVE the Security Market Line (Undervalued stock).

[ C ]In the risk-free cash quadrant.

[ D ]Directly on the origin (0, 0).

Takeaway

An overvalued stock with negative Jensen's Alpha plots below the Security Market Line, since it offers investors a lower expected return than the fair CAPM-required return for its level of systematic (beta) risk.

Derivation

The SML plots the CAPM-required return for every level of beta; any security is 'fairly priced' if it sits exactly on the line, meaning its expected return exactly compensates for its systematic risk. A stock plotting below the line is offering less return than its beta risk warrants — implying its current price is too high relative to its expected future cash flows (overvalued), which mathematically corresponds to negative Jensen's Alpha (actual/expected return minus CAPM-required return). Conversely, a stock plotting above the SML is undervalued with positive alpha. This above/below-the-line mapping to overvalued/undervalued is a core application of CAPM that the exam tests directly.

Why the others fail

B — ABOVE the Security Market Line (Undervalued stock).

Assets plotting above the SML are undervalued, offering more return than their beta risk requires (positive Alpha) — the opposite characterization of the overvalued, negative-Alpha stock in question.

C — In the risk-free cash quadrant.

A risk-free cash position plots exactly on the SML's y-intercept at the risk-free rate (zero beta), not below the line, and is unrelated to describing an overvalued equity security.

D — Directly on the origin (0, 0).

The origin (0,0) represents zero risk and zero return, a point distinct from both the risk-free intercept and the below-the-line position of an overvalued, negative-Alpha security.