Capital Asset Pricing Model

Under CAPM, a stock's required return rises as its:

1. A.Book value risesBook value is an accounting measure of net assets and appears in valuation ratios, not in the CAPM equation. CAPM contains only the risk-free rate, beta, and the market risk premium.
2. B.Trading volume dropsFalling volume suggests thinner liquidity, and investors do demand compensation for illiquidity in the real world, so this has surface appeal. CAPM does not price liquidity at all; systematic risk measured by beta is its single risk input.
3. C.Dividend yield fallsThis confuses required return with the dividend yield component of realized return. CAPM sets the return investors demand for bearing systematic risk, regardless of whether that return arrives as dividends or appreciation.
4. D.Beta increasesCorrect - required return scales with beta.

Why: Higher beta means more systematic risk, so CAPM requires a higher expected return.

The Capital Asset Pricing Model (CAPM) relates an asset's expected return to its:

1. A.LiquidityIlliquidity is genuinely compensated in real markets, which is why this is tempting. CAPM contains no liquidity term at all: its inputs are the risk-free rate, beta, and the market risk premium.
2. B.Total risk (standard deviation)Standard deviation captures total risk, systematic plus unsystematic. CAPM prices only the systematic portion, on the reasoning that unsystematic risk can be diversified away and so earns no premium.
3. C.Systematic risk (beta)Correct - CAPM uses beta.
4. D.Credit ratingCredit ratings measure default risk and belong to fixed-income analysis. CAPM is a general model of expected return driven by market sensitivity, and it applies to equities that have no credit rating at all.

Why: CAPM prices expected return based on systematic risk, measured by beta.

Using CAPM with a 4% risk-free rate, a beta of 1.0, and an 8% expected market return, the expected return is:

1. A.6%This splits the difference between the 4% risk-free rate and the 8% market return instead of running the formula. CAPM does not average the two inputs; it adds beta times the market risk premium to the risk-free rate, and with beta of 1.0 the full premium is earned.
2. B.4%This stops at the risk-free rate and drops the risk premium term entirely. That answer would only be right if beta were zero; a beta of 1.0 means the investor carries full market risk and must be compensated with the entire 4-point premium.
3. C.12%This is the classic slip of applying beta to the whole market return rather than to the excess premium, giving 4% plus 8%. The bracketed term in CAPM is the market return minus the risk-free rate, so the correct addition is 4% plus 1.0 times 4%.
4. D.8%Correct - beta 1 means market return.

Why: 4% + 1.0 x (8% - 4%) = 8%, equal to the market return.

Using CAPM with a 5% risk-free rate, a beta of 1.0, and a 10% expected market return, the expected return is:

1. A.15%This adds the full 10% market return to the 5% risk-free rate rather than the 5% risk premium. CAPM compensates the investor for the excess of the market over the risk-free rate, so the bracket is (10% - 5%).
2. B.6%This treats the beta of 1.0 as one percentage point and tacks it onto the risk-free rate. Beta is a multiplier applied to the market risk premium, not a figure measured in percent.
3. C.5%This stops at the risk-free rate and drops the risk premium, the result you would get with a beta of zero. A beta of 1.0 means the investor bears full market risk and should expect the full market return of 10%.
4. D.10%Correct - beta 1 means market return.

Why: 5% + 1.0 x (10% - 5%) = 10%, equal to the market return.