Question

The risk-free rate is 4.6 percent.  Stock A has a beta = 1.2 and Stock B has a

beta = 1.  Stock A has a required return of 12.1 percent.  What is Stock B’s

required return?

Group of answer choices

11.05%

10.85%

10.95%

11.15%

11.25%

You observe the following yield curve for Treasury securities:

Maturity             Yield

1 Year                3.20%

2 Years              4.40%

3 Years              5.20%

4 Years              5.40%

5 Years              7.40%

Assume that the pure expectations hypothesis holds.  What does the market expect will be

the yield on 3-year securities, 2 year from today?

Group of answer choices

9.30%

9.20%

9.00%

9.10%

9.40%

One-year government bonds yield 5.5 percent and 3-year government bonds yield 5.1 percent.

Assume that the expectations theory holds.  What does the market believe the rate on 2-year

government bonds will be one year from today?

Group of answer choices

4.80%

4.60%

4.70%

4.90%

5.00%

The real risk-free rate of interest is 2 percent.  Inflation is expected to be 4 percent this

coming year, jump to 6 percent next year, and increase to 7 percent the year after (Year 3).

According to the expectations theory, what should be the interest rate on 2-year, risk-free

securities today?

Group of answer choices

6.60%

6.70%

6.80%

7.00%

6.90%

Answer 1

Part 1:

As per CAPM, Required return on equity Re= Rf+B*RP

Where Rf= Risk free rate, B= Beta coefficient and RP= Risk Premium

Hence RP= (Re-Rf)/B

Given, Rf= 4.6%.

Re of Stock A=12.1% and Beta of Stock A= 1.2 Therefore, RP= (12.1-4.6)/1.2= 6.25%

Beta of Stock B= 1

Therefore, expected return of Stock B= 4.6%+1*6.25% = 10.85%

Part 2:

Yield curve on Treasury securities represent spot rates for the respective maturities. Accordingly,

Accordingly, Spot rate for 5 years (S5)= 7.40%

Spot rate for 2 years= 4.40%

Expected yield rate on 3 year bond, 2 years from now is the for 3 years, 2 years from now (forward rate from year 2 to 5 (F2,5).

F2,5 = {[(1+S5)^5/(1+S2)^2]^(1/3)}-1 = {[(1+7.40%)^5/(1+4.40%)^2]^(1/3)}-1

=[(1.428964/1.089936)^(1/3)]-1 = 1.094477-1 = 9.44774% Rounded to 9.40%

The answer is the last choice.

Part 3:

Given, S1= 5.5%   S3= 5.1%

Two-year rate, one year from now= {[(1+S3)^3/(1+S1)]^(1/2)}-1

={[(1+5.1)^3/(1+5.5)]^(1/2)}-1 = [(1.160936/1.055)^(1/2)]-1

= 1.049006 -1 =4.90057% Rounded to 4.90%

The answer is the fourth choice.

Part 4:

Nominal interest rate= Real rate plus inflation

Given, Real interest rate = 2%

Inflation expected for year 1 (i1) = 4% and for year 2 (i2)= 6%

Therefore, nominal rate for year 1 (Spot rate for year 1 or, S1)= 2%+4% = 6%

Forward rate for year 2 (one year rate expected after one year from now) (F) = Real rate +i2

=2% + 6% = 8%.

Two year interest rate ruling now is the spot rate for 2 years (S2)

S2={ [(1+S1)*(1+F)]^(1/2)}-1 = {[(1+6%)*(1+8%)]^(1/2)}-1 = [1.14480^(1/2)]-1

= 1.069953 – 1 = 6.99533% Rounded to 7%

The answer is the fourth choice.

=