Question

3a. Why are expected rate of return and required rate of return on an asset synonymous? When can they be different?

3b. What is the possible range of values for Beta?  

Please provide detailed answers.

Answer 1

3a. Expected rate of return and required rate of return on an asset is often used interchangeably in financial and capital budgeting decisions. This is because both represent the return from an asset or an investment out of the initial investment made. Some-times the expected return and required rate of return from an asset or investment remains the same.

However, these two can convey different returns for an same asset or investment. Required return represents the minimum return which the asset needs to provide. It can equal to the cost of capital or the IRR (internal rate of return) of an asset. Conversely, expected rate of return represent the return expected from an asset or investment given the time horizon, risk involved and various other factors. For financial decision making, required rate of return gets more weightage than the expected return. An asset or investment will be considered viable only if the expected return exceeds the required return. If the expected return is less than required return (even though having positive return), the asset will be considered not worth the cost spent.

3b. The beta, in financial sense, measures the volatility of return of a stock in relative to the market. It is used in Capital Asset Pricing Model (CAPM) while determining the cost of equity of a firm.

Beta can be less than 0 (negative), 0, between 0 to 1, 1,more than 1 and statistically & theoretically, till 100.

Negative Beta (less than 0) indicates that the stock movement is inverse to the market. Negative Beta can generally be attributable to commodities like gold or silver which performs better when the stock market falls.

Beta of 0 indicates there is no relation between a stock and market and the stock value remains the same irrespective of market movements. This is possible only thoertically as the movement of a stock are also dictated by factors which are specific to the stock which need not influence the market.

Beta between 0 to 1 indicates the stock volatility is lesser than the market. These are considered less risky and hence less expected returns.

Beta of 1 indicates that the stock moves exactly the way market moves. This is possible only thoertically for stocks. However, index funds which mirrors the stock indices have a beta closer to 1.

Beta more than 1 indicates the stock volatility is higher than the market. These are considered more risky and hence higher expected returns.

Generally beta ranges between 0 to 5 (rarely between 5 to 10) and hardly we see Beta exceeding 10. However, theoritically and statistically beta till 100 is possible but may not actually be possible.

Beta cannot exceed 100 statistically and logically.