CMA Final · Strategic Financial Management · Asset Pricing Theories
Market return has a standard deviation of 20% and variance of market is used in beta. Stock X has a standard deviation of 30% and a correlation of 0.6 with the market. Rf is 5% and the expected market return is 11%. What is the required return on X under CAPM, and what is its beta?
Beta is 0.9 and the required return is 10.4%. Beta equals the correlation of 0.6 multiplied by the ratio of standard deviations, 30 over 20, giving 0.9. CAPM then gives 5% plus 0.9 times the 6% premium, which equals 10.4%.
- ABeta 0.9; required return 10.4%Correct
- BBeta 0.9; required return 11.0%
- CBeta 1.5; required return 14.0%
- DBeta 0.4; required return 7.4%
Explanation
Beta = correlation x (sd stock / sd market) = 0.6 x 30/20 = 0.9. Required return = 5% + 0.9 x 6% = 10.4%. Beta 1.5 comes from inverting the ratio of standard deviations wrongly (0.6 is ignored) and gives 14%.
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