Question

A stock has a beta of 1.3 and an expected return of 14%. The risk free rate is 2% and the expected return on the market portfolio is 9%. How much better (or worse) is the expected return on the stock compared to what it should be according to the CAPM?

Enter answer in percents, accurate to two decimal places.

Answer 1

Solution:

As per the CAPM the expected return can be calculated using the formula

Expected return = R_F + [ β * ( R_M - R_F ) ]

Where

R_F = Risk free rate ; β = Beta   ;   R_M = Expected return on the market portfolio

As per the information given in the question we have

R_F = 2 %   ; R_M = 9 %   ; β = 1.3

Applying the above values in the formula we have

= 2 % + [ 1.3 * ( 9 % - 2 % ) ]

= 2 % + ( 1.3 * 7 % )

= 2 % + 9.10 % = 11.10 %

Thus the expected return of the stock as per CAPM = 11.10 %

As per the information given in the question

Actual expected return on stock= 14 %

Whereas expected return as per CAPM = 11.10 %

Thus the actual expected return on the stock is better than the expected return as per CAPM by

= 14 % - 11.10 % = 2.90 %

Thus the solution is 2.90 %