Question

Problem 8-08 Two stocks, A and B, have beta coefficients of 0.8 and 0.6, respectively. If the expected return on the market is 14 percent and the risk-free rate is 5 percent, what is the risk premium associated with each stock? Round your answers to two decimal places. The risk premium for stock A: The risk premium for stock B:

Answer 1

Risk Premium is extra return over risk free rate

As per CAPM Model ERi = Rf + B* (Rm - Rf) Where ERI = Expected Return on stock Rf = Risk Free Rate B = Beta of the security Rm = Return on Market Rm - Rf = Market Risk Premium

For Stock A

ER (A) = 5% + 0.8 * (14% - 5%)

ER (A) = 5% + 7.2%

ER (A) = 12.2%

Hence, Risk Premium of Stock A = Return of Stock A - Risk free rate

Risk Premium of Stock A = 12.2% - 5%

Risk Premium of Stock A = 7.2%

For Stock B

ER (B) = 5% + 0.6 * (14% - 5%)

ER (B) = 5% + 5.4%

ER (B) = 10.4%

Hence, Risk Premium of Stock B = Return of Stock B - Risk free rate

Risk Premium of Stock B = 10.4% - 5%

Risk Premium of Stock B = 5.4%