Question

The two-factor model on a stock provides a risk premium for exposure to market risk of 9%, a risk premium for exposure to interest rate risk of (-1.3%), and a risk-free rate of 3.5%. The beta for exposure to market risk is 1, and the beta for exposure to interest rate risk is also 1. What is the expected return on the stock? a. 15.2% b. 11.2% c. 13.8% d. 8.7%

Answer 1

The factor model hence created is-

Expected return on stock = Risk free rate + beta for exposure to market risk(premium for exposure to market risk) + beta for exposure to interest rate risk(interest rate risk premium)

Expected return on stock = 3.5% + 1(9%) + 1(-1.3%)

Expected return on stock = 3.5% + 9% - 1.3%

Expected return on stock = 11.2% (option b)

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