Financial Risk Manager Part 1
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Company ABC is expected to return 15% per year to its investors, the market expected return is 8%, and the risk-free rate is 3.5%. What is ABC's stock beta?
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TTanishq
A
1.4375
B
1.875
C
2.5556
D
3.3333
Explanation:
Explanation
This question uses the Capital Asset Pricing Model (CAPM) formula:
Where:
- = Expected return of the stock = 15%
- = Risk-free rate = 3.5%
- = Expected market return = 8%
- = Stock beta (what we're solving for)
Step-by-step calculation:
- Plug in the known values:
15
\% = 3.5\% + \beta_i(8\% - 3.5\%)$$8% - 3.5% = 4.5%3. Rewrite the equation: $$4. Subtract the risk-free rate from both sides: 15\% - 3.5\% = 4.5\%\beta_i$$ $$5. Solve for beta:
Interpretation: A beta of 2.5556 means that Company ABC's stock is highly volatile compared to the overall market. For every 1% change in the market return, ABC's stock is expected to change by approximately 2.56%. This high beta is consistent with the stock's high expected return of 15%, as higher risk should be compensated with higher expected returns according to CAPM.
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