Question

The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to:_________

Answer 1

Answer:

13.2%

Explanation:

As per Capital Asset Pricing Model (CAPM),

Expected Rate Of Return = $R_{f} \ +\ B(R_{m} \ -\ R_{f} )$

wherein, $R_{f}$ = Risk free rate of return on treasury bonds

               B= Beta , which represents the degree of sensitivity of security return to the market return.

               $R_{m}$ = Return on market portfolio

Thus, Expected rate of return of security X = 6 + 1.2(12 - 6)

                                                                        = 13.2%

CAPM model is used for calculating expected rate of return. As per the model, the investors expect a risk premium represented by excess of rate of return of market portfolio over risk free rate , in addition for the risk free rate of return.

The risk premium serves as a compensation for investing in risky securities instead of risk free securities.