The risk-free rate is 5%; Stock A has a beta of 2.0; Stock B has a beta of 1.0;

Question

The risk-free rate is 5%; Stock A has a beta of 2.0; Stock B has a beta of 1.0; and the market risk premiumis positive. Which of the following statements is CORRECT?

A) If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.

B) If Stock A's required return is 11%, then the market risk premium is 6%.

C)If Stock B's required return is 11%, then the market risk premium is 6%.

D) Stock A's required rate of return is twice that of Stock B

Explanation / Answer

Please find the detailed answer as follows:

You need to use the CAPM model to determine the correct choice.

As per CAPM Model

Required Return = Risk Free Rate + Beta*(Market Risk Premium)

Substituting Values for Stock B,

11 = 5 + 1*Market Risk Premium

Market Risk Premium = (11 - 5)/1 = 6% (Option C is therefore correct)

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Substituting Values for Stock A,

11 = 5 + 2*Market Risk Premium

Market Risk Premium = (11 - 5)/2 = 3% (Option B is therefore incorrect)

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Option C (If Stock B's required return is 11%, then the market risk premium is 6%) is the correct answer.

Thanks.

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