A stock has a beta of 1.8. A security analyst who specializes in
studing this stock expects its return to be 18 percent. Suppose the
risk free rate is 5 per cent and the expected market risk premium is 8
percent.Is this analyst pessimistic or optimistic about this stock
relative to the markets expectations?

Hello.

Here's the formula for the Capital Asset Pricing Model (CAPM):

Expected Return = 
Risk Free Rate + (Market Return - RF Rate)*Beta  

or
Expected Return = RF Rate + (market risk premium) * Beta 

source: Investopedia.com Concepts: CAPM
http://www.investopedia.com/university/concepts/concepts8.asp

Applying the formula to the given figures:

Expected Return = RF Rate + (market risk premium) * Beta 
                = 5%      + (8%) * 1.8
                = 5%      + 14.4%
                = 19.4%

Thus, CAPM suggests that the return should be 19.4%.  Thus, an analyst
who is only expecting 18% is being PESSIMISTIC about the stock.

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search strategy:
capm "rf rate" beta

I hope this helps.

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Clarification of Answer by juggler-ga on 09 Jan 2006 09:32 PST

I hope that you didn't take the comment below by

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Clarification of Answer by juggler-ga on 09 Jan 2006 09:34 PST

I hope that you didn't allow the comment below by nimalan-ga to
mislead you. I can assure you that I have correctly applied the CAPM
model to your question and that my answer is 100% accurate.

Lets assume that the beta was -1.8. The CAPM equation gets turned on
its head. The Return then becomes negative. The issue here though is
that the risk is still inherently high @ 1.8. Thus the CAPM
incorrectly manifests an answer. And is not therefore not the correct
method to use to evaluate risks in stocks. The correlation with the
market seriously is non consequential.