Question

Assume that the risk-free rate is 4.5% and the required return on the market is 8%. What is the required rate of return on a stock with a beta of 2? Round your answer to two decimal places.

Answer 1

Before we proceed further let us discuss about CAPM approach which helps in determining the return on the stock.

Capital asset pricing model - Any investment will have two have two types of risk one is the systematic and there other is unsystematic risk systematic risk is the generalised risk almost all the stocks have to face they include inflation , Interest rate risk etc and unsystematic risk is the stock specific risk

CAPM tells us how to calculate the return of security considering the systematic risk alone

According to CAPM the formula to calculate the return on security is

Re = Rf + B( Rm- Rf)

Where Re is the required rate of return

Rf is the risk free rate

Rm is the market risk

Hence we were given Rf = 4.5%

Rm = 8

and B =2

Hence as per CAPM the required rate of return is

Re = 4.5 + 2(8-4.5)

= 4.5 + 7

11.5%

Hence the required rate of return of the stock as per CAPM is 11.5%

Note - We have assumed that all the assumptions of CAPM holds good