In: Finance
A stock has a required return of 12%, the risk-free rate is 6.5%, and the market risk premium is 2%.
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Stock's required rate of return will be %.
Required rate of return = 12%
Risk free rate = 6.5%
Market risk premium = 2%
(a) As per Capital Asset Pricing Model
Required rate of return = risk free rate + Beta ( market risk premium)
Putting values in the formula
12% = 6.5% + Beta ( 2%)
12% - 6.5% = Beta (2%)
5.5% / 2% = Beta
2.75 = Beta
So, Beta of stock is 2.75
(b)
If market risk premium increase to 3% and beta and risk free rate remains constant then
Required rate of return = risk free rate + beta( market risk premium)
Required rate of return = 6.5% + 2.75 (3%)
= 6.5% + 8.25%
= 14.75%
Stock required rate of return = 14.75%
Right option is
(I) if stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in market risk premium.
Reason :- in this question , beta is 2.75 that means greater than 1 and change in required rate of return in 14.75 % - 12% = 2.75% and change in market risk premium is 3% - 2% = 1%
So, change in required rate of return is greater than change in market risk premium if beta is greater than 1.