Question

Suppose you are examining a stock with a beta of 0.6 at a time when the market has an expected rate of return of 12%. If the risk free rate of return is 2%, then the capital asset pricing model predicts that the stock return will be closest to ___________.

Answer 1

Answer:

8%

Explanation:

The capital asset pricing model (CAPM) models the relationship between the expected stock return and systematic risk. Systematic risk here refers to market risk and not risk unique to the stock. Systematic risk includes global financial crisis, political instability etc.

The CAPM models expected return (Er) as:

Er = Rf + β(Rm - Rf)

where Er is expected return; β is beta of 0.6; Rm is market return of 12%; and Rf is the risk free rate 2%.

Thus, Er = 2% + 0.6(12% - 2%)

= 2% + 0.6(10%)

=2% + 6%

=8%

This means that the capital asset pricing model predicts that the stock return will be close to 8%.