Assume that the risk-free rate is 5 percent and the market risk premium is 6 percent. What is the expected return for the overall stock market? What is the required rate of return on a stock with a beta of 1.2?

Access the Thomson ONE problems though the ThomsonNOW Web site. Use the Thomson ONE—Business School Edition online database to work this chapter’s questions.

Using Past Information to Estimate Required Returns

Chapter 8 discussed the basic trade-off between risk and return. In the Capital Asset Pricing Model (CAPM) discussion, beta is identified as the correct measure of risk for diversified shareholders. Recall that beta measures the extent to which the returns of a given stock move with the stock market. When using the CAPM to estimate required returns, we would ideally like to know how the stock will move with the market in the future, but since we don’t have a crystal ball we generally use historical data to estimate this relationship with beta.

As mentioned in the Web Appendix for this chapter, beta can be estimated by regressing the individual stock’s returns against the returns of the overall market. As an alternative to running our own regressions, we can instead rely on reported betas from a variety of sources. These published sources make it easy for us to readily obtain beta estimates for most large publicly traded corporations. However, a word of caution is in order. Beta estimates can often be quite sensitive to the time period in which the data are estimated, the market index used, and the frequency of the data used. Therefore, it is not uncommon to find a wide range of beta estimates among the various published sources. Indeed, Thomson One reports multiple beta estimates. These multiple estimates reflect the fact that Thomson One puts together data from a variety of different sources.