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Risk and Returnbeginner
CAPM Expected Return
Use the Capital Asset Pricing Model to find the expected return on a stock.
Problem Scenario
Risk-free rate is 4%, market return is 11%, and the stock's beta is 1.4.
Given Data
Risk-free rate4%
Market return11%
Beta1.4
Requirements
- Calculate expected return using CAPM
- Interpret the result
Solution
Step 1:
CAPM: E(R) = Rf + β(Rm - Rf).
Step 2:
E(R) = 0.04 + 1.4 × (0.11 - 0.04) = 0.04 + 1.4 × 0.07.
Step 3:
E(R) = 0.04 + 0.098 = 0.138.
Final Answer
Expected return = 13.8%. Investors require 13.8% to hold this stock.
Key Takeaways
- ✓Higher beta means higher required return
- ✓Market risk premium = Rm - Rf
Common Errors to Avoid
- ✗Using market return instead of market risk premium
- ✗Mixing up Rm and Rm-Rf
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Common questions about this problem type
No. It is the expected (average) return required to compensate for systematic risk.
The stock is underperforming relative to its risk. On the Security Market Line, it would plot below the line, suggesting it is overvalued at the current price.