Question

Which one of the following stocks is correctly priced if the risk-free rate of return is 4.1 percent and the market risk premium is 8.6 percent?

stock c

stock b

stock a

stock d

stock e

Stock	Beta			Expected Return
A		.81			7.88	%
B		1.57			12.69
C		1.38			11.35
D		1.37			11.99
E		.95			12.27

Answer 1

Given the following information,

Risk free rate = Rf = 4.1% = 0.041

Market risk premium = 8.6% = 0.086

We know that,

E(Ri) = Rf + β*(E(Rm) - Rf)

Where

E(Ri) = Capital asset expected return

Rf = Risk free rate

β = sensitivity

E(Rm) = Expected return of the market

and

(E(Rm) - Rf) = the market risk premium

So the above formula can be written as

E(Ri) = Risk free rate + beta*market risk premium

Calculation of E(Ri) for the given stocks as follows,

Stocks	Beta	Rf	Market risk premium	beta*market risk premium	E(Ri)	%
A	0.81	0.041	0.086	0.81*0.086 = 0.06966	0.1107	11.07
B	1.57	0.041	0.086	1.57*0.086 = 0.13502	0.1760	17.60
C	1.38	0.041	0.086	1.38*0.086 = 0.11868	0.1597	15.97
D	1.37	0.041	0.086	1.37*0.086 = 0.11782	0.1588	15.88
E	0.95	0.041	0.086	0.95*0.086 = 0.08170	0.1227	12.27

From the above it is clear that,

The expected return on the stock E is 12.27% from the calculation, so

Ans is Stock E