Question

How is a stock’s expected return related to its beta?

• A. There is a nonlinear relationship

• B. There is a parabolic relationship

• C. There is a linear relationship

• D. Non of the above

Answer 1

Expected return is calculated by solving the below equation

Cost of equity = Risk free rate + beta x (Market return - Risk free rate)

As none of the terms has a power greater than 1, the relation between the expected return or the cost of equity and beta is linear. So the correct option is C

For parabolic relationship, the change in expected return should be of the form of a squared power of beta. For non linear relationship, the power of the terms should be greater than 1. This makes options A and B incorrect and option D is also incorrect because there is a linear relationship.