The risk-free rate is 1.25%, the market rate of return is 8%, the standard deviation of XYZ stock is 20, and the beta of XYZ stock is 1.10. What is the expected return of XYZ stock?

• A. 8.68%
• B. 12.2%
• C. 12.1%
• D. 7.7%

Answer: (A)

To determine the expected return of XYZ stock, we can utilize the Capital Asset Pricing Model (CAPM), which is typically represented by the formula:

Expected Return = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)

In this case, we have:

• Risk-Free Rate = 1.25%

• Market Rate of Return = 8%

• Beta of XYZ stock = 1.10

First, calculate the market risk premium, which is the difference between the market rate of return and the risk-free rate:

Market Risk Premium = Market Rate of Return - Risk-Free Rate

Market Risk Premium = 8% - 1.25%

Market Risk Premium = 6.75%

Next, apply the CAPM formula. Using the calculated market risk premium:

Expected Return = 1.25% + 1.10 * 6.75%

Expected Return = 1.25% + 7.425%

Expected Return = 8.675%

Rounding this value gives us approximately 8.68%.

Thus, the expected return of XYZ stock is 8.68%, which corresponds to the first choice, making it the correct answer. This shows how the CAPM formula integrates the