Question

The expected return on the stock market is 0.12 (12%) with a variance of 0.374. If the riskfree rate is 3%, calculate the expected return for stock XYZ that has a covariance (COV) of 0.14 with the market return. (Answer to the nearest 0.1%)

a) 15.0% b) 12.0% c) 4.3% d) 6.4% e) 7.8%

Answer 1

Co-variance = Beta of XYZ x Beta of Market x Variance of Market
That is, 0.14 = Beta of XYZ x 1 x 0.374
So Beta of XYZ = 0.14 / (1 x 0.374) = 0.374

As per CAPM, Expected Return = Risk Free Rate + Beta x (Market Return - Risk Free Rate)
That s, 3% + 0.374 x (12% - 3%) = 3% + 3.366% = 6.366%; rounding up, it becomes 6.4%

So the answer is option d) 6.4%

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