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Which one of the following should earn the most risk premium based on Capital Asset Pricing...

Which one of the following should earn the most risk premium based on Capital Asset Pricing Model (CAPM)?

U.S. Treasury bill.

Stock with a beta of 0.74.

Stock with a beta of 1.38.

Stock with a beta of 1.01.

Solutions

Expert Solution

In order to calculate the risk premium of the various options, we need to take the risk free rate and expected returns in all the three options to to be constant.

Lets assume the Risk free rate = 6% and Expected return = 12%

Now we can calculate the risk premium of each stock as follows

Expected Return = Risk free rate + Beta * (Market Risk Premium)

A) Expected Return = 12% , Risk free rate = 6% , Beta = 0.74

Market Risk Premium = (Expected Return - Risk free rate) / Beta

= (12 - 6) / 0.74

= 8.11%

Market Risk premium comes out to be 8.11%

B) Expected Return = 12% , Risk free rate = 6% , Beta = 1.38

Market Risk Premium = (Expected Return - Risk free rate) / Beta

= (12 - 6) / 1.38

= 4.35%

Market Risk premium comes out to be 4.35%

C) Expected Return = 12% , Risk free rate = 6% , Beta = 1.01

Market Risk Premium = (Expected Return - Risk free rate) / Beta

= (12 - 6) / 1.01

= 5.94%

Market Risk premium comes out to be 5.94%

So we can see that the market risk premium is highest for stock with lowest beta.

Therefore the Stock with a beta of 0.74, earns the most risk premium.

Hope I was able to solve your concern. If you are satisfied hit a thumbs up !!

jeff jeffy answered 1 year ago
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