The market risk premium is 8%. If the risk-free rate of return is 2% and the beta of a security is 1.3, what is the expected return for the security for the next year?

- 12.4%
- 13.0%
- 13.4%
- 15.0%

Solution: The market risk premium is the difference between what the market is expected to return and the risk-free rate of return. We multiply this number by the beta and then add the risk-free rate of return: (1.3 x 8%) + 2% = 12.4%. The correct answer is a.

CAPM: E(r) = Rf + [E(rm) – Rf] where E(r) is the expected return, Rf is the risk-free rate of return, and E(rm) is the expected return of the market.

[E(rm) – Rf] is the market risk premium.