Question

THY stock has an expected return of 19 percent with a beta of 1.7, while Pegasus stock has an expected return of 14 percent with a beta of 1.2. Assume the CAPM is true. What is the expected return on the market? What is the risk-free rate? Note: beta of the market is one, CAPM is defined with security market line.

Answer 1

Answer;

Risk Free rate = 2%

Market return = 12%

CAPM

Expected return of security = Rf + Beta ( Rm-Rf)

Step 1

THY Expected return = 19%

Beta = 1.7

Market risk premium = (Rm- Rf) = Assum MRP

so, 19 = Rf + 1.7 (MRP)

Rf = 19 - 1.7 (MRP) --------------- (A)

Step 2

Pegasus Expected return = 14%

Beta = 1.2

Market risk premium = (Rm- Rf) = Assum MRP

so, 14 = Rf + 1.2 (MRP)

Rf = 14 - 1.2 (MRP) --------------- (B)

Step 3 (A) + (B)

19 - 1.7 (MRP) =14 - 1.2 (MRP)

1.7 MRP - 1.2 MRP = 19 -14

.5 MRP = 5

MRP = 5/.5

MRP = 10%

so,as per equition (A)

Rf = 19 - 1.7 (MRP)

Rf = 19 - 1.7(10)

Rf = 19 - 17

Rf = 2%

Market Return = MRP + Rf

Market return = 10 + 2 = 12%

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