Question

Throughout this problem assume that the expected market risk premium is 4% with a standard deviation of 20% and that the risk-free interest rate is 0%.

A stock has a beta of 2.1.

Question: Explain what beta measures and compute the stock’s expected return.

Answer 1

Beta is the measurement of the movement of the stock in relation to the market. It tells us the direction and magnitude of stock's return in relation to the market. For example, if there is a stock having a beta of 2, it means that if market return is going to increase by 10%, the stock will increase by 20%(2*10%). This also states that if market falls by 5%, the stock will fall by 10%. This basically gives an idea about the aggressive or neutral nature of the stock in relation to the movements in the market.

Calculation of expected return

Expected return can be calculated using Capital Asset Pricing Model (CAPM) using the following equation:

Risk Free Rate + Beta * Risk Premium

Given that,

Risk Free Rate = 0%

Beta = 2.1

Risk Premium = 4%

Thus, Expected return using CAPM is:

= 0% + 2.1 * 4%                                           (Substituting the values in CAPM)

= 8.4%

Expected return of the stock is 8.4%