Homework: HW3, FRL301.003 Revlew Question 8 (of 14)Score This Question 8. value:
ID: 2780039 • Letter: H
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Homework: HW3, FRL301.003 Revlew Question 8 (of 14)Score This Question 8. value: 10.00 points Suppose you observe the following situation: Pete Corp. Repete Co. Beta 1.10 .79 -120 093 Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) What is the risk-free rate? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g, 32.16.) Risk-free rate Referen ces eBook & ResourcesExplanation / Answer
Here we have the expected return and beta for two assets. We can state the returns of the two assets by using CAPM. If the CAPM is right, then the security market line holds as well, which means all assets have the same risk premium. Setting the risk premiums of the assets the same to each other and solving for the risk-free rate, then we can find:
If we take Pete corp. is Security A and Repete co. as security B; and Expected return is taken as R; then the equation will be
R of Sec A – Rf/ of SecA = R of Sec B – Rf / of SecB
(0.120 – Rf)/1.10 = (0.093 – Rf)/0.79
0.79(0.120 – Rf) = 1.10(0.093 – Rf)
0.0948 – 0.79 Rf) = 0.1023 – 1.10 Rf
1.10Rf – 0.79 Rf = 0.1023 – 0.0948
0.31 Rf = 0.0075
Rf = 0.0075/0.31
Rf = 0.02419 or 0.0242
Rf = 0.0242 or 2.42%
Now using CAPM to find the expected return on the market with both stocks, we find:
R of Sec A = Rf + of SecA (RM - Rf)
0.120 = 0.0242 + 1.10(RM – 0.0242)
0.120 = 0.0242 + 1.10 RM – 0.02662
- 1.10 RM = 0.0242 – 0.02662 – 0.120
= 0.0243 – 0.14662
= - 0.12232
RM = - 0.12232/1.10
RM = 0.1112 or 11.12%
Expected Return on the market (RM)
11.12
%
Risk free rate (Rf)
2.42
%
Expected Return on the market (RM)
11.12
%
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