Question

If the current risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, r _M – r _RF, is positive. Which of the following statements is CORRECT?

	a.	If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.
	b.	If Stock B's required return is 11%, then the market risk premium is 2.5%.
	c.	If Stock A's required return is 11%, then the market risk premium is 2.5%.
	d.	If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.
	e.	Stock B's required rate of return is twice that of Stock A.

Answer 1

Given that;
Risk free rate is 6%
Beta of stock A is 1.
Beta of stock B is 2.
Market risk premium is positive.
According to CAPM:
Required return=Risk free rate + (Beta)*(Market risk premium)

If the risk-free rate increases but the market risk premium stays unchanged then the required return for both stock A and stock B will remain unchanged because beta multiplied with market risk premium will remain unchanged.
If market risk premium is 11%
For stock B;

11%=6% + (2)*(Market risk premium)
=>11%-6%=(2)*(Market risk premium)
=>5%=(2)*(Market risk premium)
=>Market risk premium=5%/2=2.50%

Answer: Hence, option b is correct.