Using CAPM with risk-free rate 2%, expected market return 8%, and beta 1.2, what is the expected return?

Using CAPM with risk-free rate 2%, expected market return 8%, and beta 1.2, what is the expected return?

• A. 6.8%
• B. 11.0%
• C. 8.0%
• D. 9.2%

Answer: (D)

The concept tested is CAPM, which ties an asset’s expected return to the risk-free rate plus a risk premium that depends on beta. The risk premium in CAPM is the market risk premium, calculated as the expected market return minus the risk-free rate. Then you scale that premium by the asset’s beta and add the risk-free rate. Compute step by step: market risk premium = 8% − 2% = 6%. Multiply by beta: 1.2 × 6% = 7.2%. Add the risk-free rate: 2% + 7.2% = 9.2%. So the expected return is 9.2%. This reflects taking on more systematic risk (beta greater than 1) and therefore demanding a higher return than the risk-free rate. Values like 6.8%, 8.0%, or 11.0% would result from using different betas (for example, 0.8, 1.0, or 1.5) rather than the given beta of 1.2.

The concept tested is CAPM, which ties an asset’s expected return to the risk-free rate plus a risk premium that depends on beta. The risk premium in CAPM is the market risk premium, calculated as the expected market return minus the risk-free rate. Then you scale that premium by the asset’s beta and add the risk-free rate.

Compute step by step: market risk premium = 8% − 2% = 6%. Multiply by beta: 1.2 × 6% = 7.2%. Add the risk-free rate: 2% + 7.2% = 9.2%.

So the expected return is 9.2%. This reflects taking on more systematic risk (beta greater than 1) and therefore demanding a higher return than the risk-free rate. Values like 6.8%, 8.0%, or 11.0% would result from using different betas (for example, 0.8, 1.0, or 1.5) rather than the given beta of 1.2.