Stock A has a beta of 0.5, and investors expect it to return 3%. Stock B...

Stock A has a beta of 0.5, and investors expect it to return 3%. Stock B has a beta of 1.5, and investors expect it to return 5%. Use the CAPM to calculate the market risk premium and the expected rate of return on the market. (Enter your answers as a whole percent.)

Market Risk Premium : ____ %

Expected market rate of return ___ %

Solutions

Expert Solution

Given that, stock A has a beta of 0.5, and investors expect it to return 3%. Stock B has a beta of 1.5, and investors expect it to return 5%

Expected return=Risk free rate+Beta*(Expected market rate of return-Risk free rate)
Expected market rate of return-Risk free rate=Market Risk Premium
So, Expected return=Risk free rate+Beta*Market Risk Premium

For stock A:
Beta=0.5
Expected return=3%
So, 3%=Risk free rate+.5*Market Risk Premium

For stock B:
Beta=1.5
Expected return=5%

So, 5%=Risk free rate+1.5*Market Risk Premium

Now, we have two equations

3%=Risk free rate+.5*Market Risk Premium ....... (Equation 1)
5%=Risk free rate+1.5*Market Risk Premium ..... (Equation 2)
Subtracting equation 1 from equation 2, we get

5%-3%=(Risk free rate+1.5*Market Risk Premium) - (Risk free rate+.5*Market Risk Premium)
=>2%=Risk free rate+1.5*Market Risk Premium - Risk free rate-.5*Market Risk Premium
=>2%=Risk free rate - Risk free rate+1.5*Market Risk Premium -.5*Market Risk Premium
=>2%=Market Risk Premium

Substituting the value of market risk premium in equation 2, we get

5%=Risk free rate+1.5*2%
=>0.05=Risk free rate+0.03

=>0.05-0.03=Risk free rate
=>0.02=Risk free rate

So, risk free rate is 2% and market risk premium is 2%

jeff jeffy answered 10 months ago

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