Question

Suppose you observe the following situation: Security Pete Corp. Repete Co. Beta 1.20 .89 Expected Return .130 .103 a. Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) b. What is the risk-free rate? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Expected return on market Risk-free rate

Answer 1

Expected return (CAPM) = Rf+β×Rp

Rf is risk free return

Rp is risk premium

Rf+1.2×Rp = 13% ...... (1)

Rf+0.89×Rp = 10.3% …… (2)

Do (1)-(2)

0.31×Rp = 2.7%

Market risk premium, Rp = 8.71%%

Take, Rf+1.2×Rp = 13%

Rf+1.2×8.71% = 13%

Risk free rate of return, Rf = 2.55%

Expected return on market is 11.26% (8.71%+2.55%)