Assume that the risk-free rate is 3% and the market risk premium is 7%. a. What is the required...

Question:

Assume that the risk-free rate is 3% and the market risk premium is 7%.

a. What is the required return for the overall stock market? Round your answer to two decimal places.

b. What is the required rate of return on a stock with a beta of 2.3? Round your answer to two decimal places.

Capital Asset Pricing Model:

Factors such as recession, inflation or war are risk that cannot be diversified. Different stocks have different level of sensitivity to these systematic risk. The level of risk is measured by beta. Therefore, higher the beta of a stock, higher is the required return by investors. The market portfolio has a beta of one.

Answer and Explanation:

.

Answer a

  • Risk Free Rate (Rf) = 3%
  • Market Risk Premium (Rp) = 7%
  • Market Beta (B) = 1

Therefore, return on market using the capital asset pricing model is as follows -

  • Return on Markets = {eq}Rf + ( B * Rp ) {/eq}
  • Return on Markets = {eq}3 + ( 1 * 7 ) {/eq}
  • Return on Markets = {eq}10.00 {/eq}

Answer b.

  • Risk Free Rate (Rf) = 3%
  • Market Risk Premium (Rp) = 7%
  • Stock Beta (B) = 2.3

Using the same capital asset pricing mode, the required return on stock can be calculated -

  • Required Return on Stock = {eq}Rf + ( B * Rp ) {/eq}
  • Required Return on Stock = {eq}3 + ( 2.3 * 7 ) {/eq}
  • Required Return on Stock = {eq}19.1 {/eq}

Learn more about this topic:

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Capital Asset Pricing Model (CAPM): Definition, Formula, Advantages & Example

from Financial Accounting: Help and Review

Chapter 15 / Lesson 6
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