Question

Stock A has a beta of 2.0 and an expected return of 13.0 percent. Stock B has a beta of 1.12 and an expected return of 13.70 percent. At what risk-free rate would these two stocks be correctly priced?

13.29 percent

13.98 percent

12.41 percent

14.59 percent

Answer 1

Stock A:

Beta = 2.0
Expected Return = 13.0%

Market Risk Premium = (Expected Return - Risk-free Rate) / Beta
Market Risk Premium = (0.13 - Risk-free Rate) / 2.0

Stock B:

Beta = 1.12
Expected Return = 13.70%

Market Risk Premium = (Expected Return - Risk-free Rate) / Beta
Market Risk Premium = (0.1370 - Risk-free Rate) / 1.12

Market Risk Premium of Stock A = Market Risk Premium of Stock B
(0.130 - Risk-free Rate) / 2.00 = (0.1370 - Risk-free Rate) / 1.12
0.1456 - 1.12 * Risk-free Rate = 0.2740 - 2.00 * Risk-free Rate
0.88 * Risk-free Rate = 0.1284
Risk-free Rate = 0.1459
Risk-free Rate = 14.59%

These two stocks will be correctly priced when risk-free rate is 14.59%