Stock A has a beta of 0.5, and investors expect it to return 5%. Stock B has a beta of 1.5, and investors expect it to return 9%. Use the CAPM to calculate the market risk premium and the expected rate of return on the market. (Enter your answers as a whole percent.)
a.Market Risk Premium =
b.Expected Rate of Return =
a)
As per capital asset pricing model, required rate of return is given by
Re = Rf + ( Rm – Rf ) x Beta
Where,
Re = Required rate of return
Rf = Risk free rate of return
Rm – Rf = Market risk premium
Beta = Beta of the stock
For Stock A,
5 = Rf + (Rm – Rf) x 0.50 --------------------- ( 1 )
For Stock B,
9 = Rf + ( Rm – Rf ) x 1.5 --------------------- ( 2 )
Deducting 1 from 2 we get
9 – 5 = Rf – Rf + Market Risk Premium x ( 1.5 – 0.50 )
So, Market Risk Premium x 1 or Market Risk Premium = 9 – 5 = 4%
b)
Putting the value of market risk premium in equation 1 we get
5 = Rf + 4 x 0.50
So, Rf = 5 – 2 = 3%
Putting the value of Rf in Rm – Rf
So, expected rate of return on market ( Rm )
Rm – 3 = 4
So, Rm = 4 + 3 = 7%
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