Question

Suppose you observe the following situation:

Answer 1

Answer:

The answer is:

* Expected return on the market: 2.74%

* Risk-free rate: 11.45%

Explanation:

Denote Rm is expected return on the market and Rf is risk-free rate. We have:

* For stock Pete: 14.5% = Rf + 1.35 x ( Rm - Rf) and

* For stock Repete: 11.8% = Rf + 1.04 x (Rm-Rf)

From the two equations above, we have: 0.31 * (Rm- Rf) = 2.7% <=> Rm - Rf = 8.71%;

So we have: 14.5% = Rf + 1.35 * 8.71% <=> Rf = 2.74%;

=> Rm = 2.7% + Rf = 8.71% + 2.74% = 11.45%.

So, Rf = 2.74%; Rm = 11.45%.