Question

Stock A has a beta of .5, and investors expect it to return 5%.

Answer 1

Answer:

The expected rate of return and the market risk premium on the market is 7% and 4% respectively

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

Let us assume Risk free-rate of return be X

And, the market rate of return be Y

For Stock A

5% = Risk-free rate of return + 0.5 × (Market rate of return - Risk-free rate of return)

5% = X + 0.5 × (Y - X)

5% = 0.5X + 0.5Y

For Stock B

9% = Risk-free rate of return + 1.5 × (Market rate of return - Risk-free rate of return)

9% = X + 1.5 × (Y - X)

9% = -0.5X + 1.5Y

By comparing the equations,

14% = 2Y

Y = 7%

And, X equals to

5% = 0.5X + 3.5%

1.5% = 0.5X

X = 3%

So, expected rate of return is 7%

And the market risk premium

= 7% - 3%

= 4%