Question

Stock R has a beta of 2.0, Stock S has a beta of 0.25, the required return on an average stock is 13%, and the risk-free rate of return is 3%. By how much does the required return on the riskier stock exceed the required return on the less risky stock? Round your answer to two decimal places.

%

Answer 1

Sol:

Stock R

Beta (B) = 2

Market return = 13%

Risk-free rate = 3%

Required return on stock = Risk-free rate + B * (Market return - Risk-free rate)

Required return on stock = 3% + 2 * (13% - 3%)

Required return on stock = 3% + (2 * 10%)

Required return on stock = 0.03 + 0.20 = 0.23 or 23%

Stock S

Beta (B) = 0.25

Market return = 13%

Risk-free rate = 3%

Required return on stock = Risk-free rate + B * (Market return - Risk-free rate)

Required return on stock = 3% + 0.25 * (13% - 3%)

Required return on stock = 3% + (0.25 * 10%)

Required return on stock = 0.03 + 0.025 = 0.055 or 5.5%

Required return on the riskier stock exceeds the required return on the less risky stock:

Required return on stock R - Required return on stock S

23% - 5.5% = 17.5%

Therefore difference in return will be 17.5%