Question

Suppose you observe the following situation:

Answer 1

Answer:

a. The expected return on the market is 10.89%

b. The risk-free rate is 1.52%

Explanation:

In order to calcuate the expected return on the market and the he risk-free rate we would have to use the following formulas:

Expected return=risk-free rate +Beta*(market rate- risk-free rate )

13.23=Rf+1.25*(Rm-Rf)

13.23=1.25Rm-0.25Rf

Rm=(13.23+0.25Rf)/1.25

To calculate the risk free rate, we use the following:

9.67=Rf+0.87*(Rm-Rf)

9.67=0.13Rf+0.87Rm

9.67=0.13Rf+0.87*(13.23+0.25Rf)/1.25

9.67=0.13Rf+9.20808+0.174Rf

Rf=(9.67-9.20808)/(0.13+0.174)

=1.52%(Approx)=risk free rate

Rm=(13.23+0.25Rf)/1.25

=10.89%(Approx)=market rate