Question

A stock has an expected return of 12 percent, its beta is 1.25, and the risk-free rate is 4 percent. What must the expected return on the market be?

Answer 1

The expected return on the market must be 10.4% based on the provided expected stock return, beta, and risk-free rate, calculated using the Capital Asset Pricing Model (CAPM).

Step-by-step explanation:

The student is asking about the expected return on the market, which can be determined using the Capital Asset Pricing Model (CAPM). The CAPM formula is Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). Given the expected return on the stock is 12%, the beta is 1.25, and the risk-free rate is 4%, we can rearrange the formula to solve for the market return:

12% = 4% + 1.25 * (Market Return - 4%)

Solving for Market Return:

12% - 4% = 1.25 * (Market Return - 4%)

8% = 1.25 * Market Return - 1.25 * 4%

Add 1.25 * 4% to both sides:

8% + 1.25 * 4% = 1.25 * Market Return

8% + 5% = 1.25 * Market Return

13% = 1.25 * Market Return

Divide both sides by 1.25:

Market Return = 13% / 1.25

Market Return = 10.4%

The expected return on the market must be 10.4% to justify the stock's expected return and beta. This is an essential concept in financial investment analysis.