Question

The​ risk-free rate is 4.3​% and you believe that the​ S&P 500's excess return will be 9.8​% over the next year. If you invest in a stock with a beta of 1.2 ​(and a standard deviation of ​30%), what is your best guess as to its expected excess return over the next​ year?

Answer 1

Using the capital asset pricing model (CAPM), the stock's expected excess return is calculated to be 10.9%, based on the provided risk-free rate, market excess return, and the stock's beta.

Step-by-step explanation:

The student's question relates to the calculation of expected excess return for a stock with a given beta. The beta of a stock indicates its volatility relative to the market. In this case, the capital asset pricing model (CAPM) is used to estimate the expected excess return. The formula for CAPM is:

Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

Given a risk-free rate of 4.3%, an expected market excess return of 9.8%, and the stock's beta of 1.2, we can calculate the stock's expected excess return as follows:

Expected Excess Return = 4.3% + 1.2 x (9.8% - 4.3%)

Expected Excess Return = 4.3% + 1.2 x 5.5%

Expected Excess Return = 4.3% + 6.6%

Expected Excess Return = 10.9%

Therefore, the best guess for the stock's expected excess return over the next year is 10.9%.