Question

Stock A has a return volatility of 10% and a beta of 0.9. Stock B has a return volatility of 20% and a beta of 0.6. According to the CAPM, which of the following statements is true?

A. Stock A should have a higher expected return.
B. Stock B should have a higher expected return.
C. Stock A’s expected return should be higher than that of the market portfolio.
D. Not enough information is provided.

Answer 1

A. Stock A should have a higher expected return.

Step-by-step explanation:

Capital Asset Pricing Model (CAPM) formula is used to calculate expected return of a stock and the formula is as follows;

CAPM; r = risk free rate + beta(Market risk premium)

Since beta is in the CAPM and determines the rate of return, we will use beta to compare these two stocks. The higher the beta, the higher the rate of return. Stock A has a beta of 0.9 which is higher than that of B (0.6). Therefore, stock A's stock return will be higher than that of B but lower than the market return since beta of the market is 1.0.