As a follow up to yesterday’s licensing exam study question, here is your question PLUS answer and rationale:
Given the following assumptions for stock ABC, what is its expected return using the Capital Asset Pricing Model (CAPM)?
Assumptions: Risk Free Rate: 1%; Expected Return on general stock market: 7%; Beta: 1.; Sharpe Ratio: 2.
Correct Answer: A
Rationale: The formula for the Capital Asset Pricing Model (CAPM) is given by the following: Return on Stock = Risk Free Rate + Beta of Stock x (Return on Market – Risk Free Rate). Plugging in for Stock ABC gives Return on Stock ABC = 1% + 1.5 x (7% – 1%) = 10%. Note the Sharpe Ratio is not used in the CAPM formula.
*Questions featured in the weekly study question series are sampled from Solomon’s industry-leading Online Exam Simulator.