Chartered Financial Analyst (CFA) Practice Exam Level 2

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Prepare for the CFA Exam Level 2 with flashcards and multiple-choice questions. Each question includes hints and explanations to boost your confidence and enhance your study process. Get ready for success!

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What does the formula Rs = Rf + Bs(Rm - Rf) represent?

WACC
Cap Rate
Required Rate of Return using CAPM
Free Cash Flow to the Firm

The correct answer is: Required Rate of Return using CAPM

The formula Rs = Rf + Bs(Rm - Rf) represents the required rate of return on an asset or equity, and it is derived from the Capital Asset Pricing Model (CAPM). In this equation: - Rs is the expected return on the stock or asset. - Rf is the risk-free rate, which is typically the return on government securities like Treasury bonds that are considered virtually risk-free. - Bs is the beta of the stock, which measures its sensitivity to movements in the overall market; a higher beta indicates more volatility compared to the market. - Rm is the expected return of the market as a whole. - The term (Rm - Rf) represents the market risk premium, or the additional return that investors expect from holding a risky asset over a risk-free asset. This formula provides a way to calculate the return required by investors given the risk associated with holding a particular stock compared to the overall market. Investors use CAPM to understand how much return they should expect based on the inherent risk of the asset in relation to market movements, hence making "Required Rate of Return using CAPM" the correct interpretation of this formula. On the other hand, the other options are not accurate representations of this particular formula.