A client, Marta Gomez has come to you. On the basis of an analysis of past retur

Question

A client, Marta Gomez has come to you. On the basis of an analysis of past returns and inflationary expectations, she feels that the expected return on stocks is 12%. The risk-free rate on short-term treasury securities is now 7%. The client is interested in the return prospects of Kessler Electronics Corporation. Based on monthly data from the past 5 years, she has fitted a characteristic line to the responsiveness of excess returns of the stock to excess returns of the S & P 500 Index and has found the slope of the line to be 1.67. If financial markets are believed to be efficient, what return can she expect from investing with KEC? Explain.

Explanation / Answer

Slope of the line is also called market risk premium = 1.67

Risk free rate = 0.07

According to CAPM

Expected return = rfr + i(E(Rm)-rfr)

Expected return = 0.07 + 1.67(0.12-0.07) = 0.1538 = 15.38%

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