Question

Current yield on U.S. 10-year treasury						2.5%
Average historical annual excess return for U.S. stocks						7.5%
Beta of the stock						1.25

Calculate the expected return on the stock ___________________

Answer 1

Solution :

As per Capital Asset Pricing Model ( CAPM ), the expected return of a stock is calculated using the following formula :

R_E = R_F + [ β * ( R_M - R_F ) ]

Where

R_E = Expected Return of the stock ; R_F = Risk free rate of return   ;

β = Beta of the stock ; ( R_M – R_F ) = Market risk Premium ;

As per the information given in the question we have

Current yield on U.S. 10-year treasury = Risk free rate of return   = R_F = 2.50 % = 0.0250 ;

Average historical annual excess return for U.S. stocks = Market risk Premium = ( R_M - R_F ) = 7.5 % = 0.075   ;

Beta of the stock = β = 1.25 ;

Applying the above values in the formula we have the expected return of the stock as

= 0.0250 + [ 1.25 * 0.075 ]

= 0.0250 + 0.09375

= 0.11875

= 11.875 %

Thus the expected return on the stock = 11.875 %

= 11.88 % ( when rounded off to two decimal places )

= 11.9 % ( when rounded off to one decimal place )