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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

The risk-free rate is 6% per annum and the expected return on the market portfolio is 12%. A stock of Bharat Textiles Ltd has a beta of 1.4. What is its required return under the CAPM?

The required return is 14.4%. It equals the risk-free rate of 6% plus beta of 1.4 times the market risk premium of 6%, which adds 8.4%. Omitting the risk-free rate gives only the premium of 8.4%.

  1. A14.4%Correct
  2. B16.8%
  3. C8.4%
  4. D12.0%
  5. 10.4%

Explanation

Required return = 6% + 1.4 × (12% − 6%) = 6% + 8.4% = 14.4%. The figure 16.8% results from forgetting to add the risk-free rate to the product of beta and the market return less risk-free... actually it is 1.4 × 12%. The figure 8.4% is only the risk premium.

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