Required Return

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.

A client has just sold the private company that represented most of her net worth and now holds the proceeds in cash. In updating her profile, the change that matters most is that

1. A.her time horizon has shortened, because she no longer receives income from the business.Wrong. Losing an income stream does not move any of her goals closer in time.
2. B.her risk capacity has changed, because one illiquid holding has become diversifiable liquid wealth.Correct. Composition of the balance sheet is what capacity is read from, and it has changed fundamentally.
3. C.her risk tolerance has increased, because the successful sale proved her judgement sound.Wrong. A favourable outcome is not evidence about her willingness to bear a future loss.
4. D.her required return has fallen, because the sale proceeds are now safely in hand.Wrong. Required return is set by her goals and horizon, and the sale changed neither of them.

Why: A life event changes a profile by changing an underlying fact, and here the fact that changed is the composition of the balance sheet. What had been a single illiquid holding, concentrated in one business and correlated with her own labour, is now liquid wealth that can be diversified and drawn on, which raises her capacity to bear market risk in a way nothing else in the profile has done. Her goals, her horizon and the return she needs are all unchanged by the transaction. Whether she should actually use the additional capacity is a separate question, answered by her goals and her tolerance rather than by the sale.