Stock A has a beta of .2, and investors expect it to return 4%. Stock B has a be

Question

Stock A has a beta of .2, and investors expect it to return 4%. Stock B has a beta of 1.8, and investors expect it to return 8%. Use the CAPM to find the expected rate of return and the market risk premium on the market. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

Stock A has a beta of .2, and investors expect it to return 4%. Stock B has a beta of 1.8, and investors expect it to return 8%. Use the CAPM to find the expected rate of return and the market risk premium on the market. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

Explanation / Answer

Stock A

0.04 = Rf + 0.20(Rf -Rm)

0.04 = Rf + 0.20Rf - 0.20Rm

0.04 = 1.20Rf - 0.20Rm Equation...(i)

Stock B

0.08 = Rf + 1.80(Rf - Rm)

0.08 = Rf + 1.80Rf - 1.80Rm

0.08 = 2.80 - 1.80Rm Equation...(ii)

Multiplying equation (i) by 9 we get

0.36 = 10.80Rf - 1.80Rm Equation...(iii)

Subtracting equation (ii) from equation (iii)

8Rf = 0.28

Rf = 0.035 or 3.5%

Putting the value of Rf in equation (i)

we get

0.04 = 1.20x0.035 - 0.20Rm

Rm = 0.01 or 10%

Thus,

Market rate of return = 10%%

Market risk premium = 10% - 3.50%

= 6.50%

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