Final answer:
In the CAPM, the investment with the highest beta is expected to earn the highest risk premium. For the options provided, the stock with a beta of 1.24 should command the highest risk premium because it is the most sensitive to market fluctuations and has the highest beta value.
Step-by-step explanation:
Based on the Capital Asset Pricing Model (CAPM), the investment that should earn the highest risk premium is the one with the highest beta. CAPM formula is given by:
r = r_f + β×(E(r_m) - r_f)
Where:
- r is the expected return of the investment,
- r_f is the risk-free rate,
- β (beta) is the volatility or systematic risk compared to the overall market,
- E(r_m) is the expected market return.
The beta factor represents the sensitivity of the expected excess asset returns to the expected excess market returns. Therefore, the stock with a beta of 1.24 should have the highest risk premium because it has the highest sensitivity to market fluctuations.
Regarding the given options:
- The stock with a beta of 0.63 would have a lower risk and therefore typically a lower risk premium.
- A portfolio with a beta of 1.12 would have a higher risk premium than the stock with a beta of 0.63 but lower than the stock with a beta of 1.24.
- The stock with a beta of 1.24, being higher than 1, indicates that it's more volatile than the market and hence would demand the highest risk premium.
- A diversified portfolio with returns similar to the overall market would have a beta close to 1; therefore, it would have a risk premium similar to the market average but lower than a stock with a beta higher than 1.
The U.S. Treasury bill is considered a risk-free investment, and so it has a beta of 0 and does not earn a risk premium above the risk-free rate.