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The Capital Asset Pricing Model (CAPM) shows how a stock's required return (rs) is related to its market risk, as measured by beta (b). - The required return (rs) is an annual rate of return that would be fair to stockholders considering the risk they are taking. - Beta (b) is a measure of how sensitive the stock is to overall market fluctuations. For the "average" stock, bo1, stocks with b>1 are riskier than average, while stocks with brs=rn+(rmrH)b In this equation, fff represents the risk-free interest rate, while rm represents the "market return". The market return is just the average return we expect across all stocks in the market (or the expected return on a major market index like the S\&.P 500], Exercise 1: Suppose the risk-free interest rate is 4% and the overall expected return on the stock market is 9%. What is the required return on a stock whose beta is 0.4 ? a. 6,0% b. 8.3% c. 8.0% d. 7.6% e. 3.6% Since imvesting in the stock, market is risky, tm must be higher than rr to get some people to invest in stocks instead of riskofree bonds. This difference ( rm - trth has at special name: the market risk preminn ( RPm). it is the extre return we get for being willig to irvest in the stock market. Since (mrr) is in the CAPM equation above, there is another way we could write the equation: rs=rh+(RPmto Sometimes when talking about the CAPM, instead af specifying the market matum (f m), we may specify the market risk prounium (RP m ). Exercise 2 Suppose the risk. free interest rate is 3% and the market risk premlum is 7 . What is the required return on a stock whose beta is 1.6 ? a. 14.2% b, 377% c. 153% d. 16.0% e. 19.0% Gecause the two terms sound simlar, a lot of students confuse the market return (fm) with the market risk premium (RP m ) and end up using the wror CAPM equation. To avold this mistake, pay dose attention to the information given, If you are given the market return. use this form of the CAPM equation. fs=rr+(rmrr)) If you are given the market risk promium, use this form of the CAPM: rs=rr+CPPmvb Exetcise 35 Northwest Lumber's stock has a beta of 0.9. What should its expected return be if the riskifree interest rate is 6% and the market return is 12 th? a. 10.hy b. 16. try c. 602 d. 11.4\% e. 10.14 Decause the two terms sound similar, a lot of students confuse the market return (rm) with the market risk premium (R.P m) and end up using the wrong version of the CAPM equation. To avoid this mistake, pay close attention to the information given. If you are given the market return, use this form of the CAPM equation: r5=rnf+(rm=rt))b If you are given the market risk premun, use this form of the CAPMe rs=ff+8SPm/b Exetcine 4: Hightech innovations is a riskienthan-average company, and analysts estimate that its stock has a beta of 1.5, What would be a fair rate of retura for Hightech's stock if the risk-free rate is 6% and the risk premium on the market is 7% ? a . 16.5\% b. 10.5% c. 25.5% di9.6\% e. 9.2%