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Expected returns and Alpha

Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing model for making recommendations to her clients. Her research department has developed the information shown in the following exhibit.
Forecasted Returns, Standard Deviations, and Betas
Forecasted Return Standard Deviation Beta
Stock X 14.0% 36% 0.8
Stock Y 17.0 25 1.5
Market index 14.0 15 1.0
Risk-free rate 5.0
a. Calculate expected return and alpha for each stock.
b. Identify and justify which stock would be more appropriate for an investor who wants to
i. Add this stock to a well-diversified equity portfolio.
ii. Hold this stock as a single-stock portfolio.

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Solution Preview

a. Calculate expected return and alpha for each stock.

Alpha = Forecasted Return - Expected return
We calculate the expected return using CAPM
Expected return = Risk Free Rate + (Market return - risk free rate ) X beta
Stock X
Expected Return = 5% ...

Solution Summary

The solution explains the calculation of expected returns and alpha