Question

Number 1

(a) What is the expected annual return on Caterpillar if it has a beta of 0.90; the annual one-year Treasury bill rate is 2.24%%; and the expected return on the Standard & Poor’s 500 is 8%? Also, please explain, in a few sentences, the intuition behind your result (i.e., the relationship between beta and expected return).

(b) In the above problem, if the twenty-year bond interest rate increases to 6.88%, what is the percentage change in the price of the bond? Please briefly explain why the price changed the way it did.

Answer 1

Rf = 2.24
Market risk premium = 8-2.24=5.76%
Using CAPM:
return = Rf+(Beta* Market rsik premium)
=2.24+(0.9*5.76)
=7.424%

As we can see this return is a bit less than market return. This stems from the fact that caterpillar with a beta of 0.9 is less risky than the amrket whose beta is 1. The lower the beta, lesser the risk and lesser the return required by the investors. A company with a beta more than 1 shall have expected return more than 8%. A firm with a beta of 1.1 shall have expected return = 2.24+(1.1*5.76)=8.576%. now this is higher than 8% market return.

Part b) Some info is missing. Kindly provide in comment section and we shall be happy to help.