According to CAPM, if the risk-free rate is 2%, the expected market return is 8%, and the beta of a stock is 1.3, what is the stock's expected return?

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Study for the Finance and Investment Challenge Test. Approaches include flashcards and multiple-choice questions with hints and explanations. Ready yourself to ace the exam!

Multiple Choice

According to CAPM, if the risk-free rate is 2%, the expected market return is 8%, and the beta of a stock is 1.3, what is the stock's expected return?

Explanation:
CAPM says the expected return equals the risk-free rate plus beta times the market risk premium (Rm − Rf). With Rf = 2%, Rm = 8%, the market risk premium is 6%. Multiply by the stock’s beta of 1.3: 1.3 × 6% = 7.8%. Add the risk-free rate: 2% + 7.8% = 9.8%. So the stock’s expected return is 9.8%. A beta above 1 means the stock should earn more than the market to compensate for higher systematic risk, which is exactly reflected here. The other option values would require different inputs or a misapplication of the formula, given these numbers.

CAPM says the expected return equals the risk-free rate plus beta times the market risk premium (Rm − Rf). With Rf = 2%, Rm = 8%, the market risk premium is 6%. Multiply by the stock’s beta of 1.3: 1.3 × 6% = 7.8%. Add the risk-free rate: 2% + 7.8% = 9.8%. So the stock’s expected return is 9.8%. A beta above 1 means the stock should earn more than the market to compensate for higher systematic risk, which is exactly reflected here. The other option values would require different inputs or a misapplication of the formula, given these numbers.

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