Question

What is the expected return on the market portfolio at a time when the risk free rate (e.g., T-Bill rate) is 4% and a stock with a beta of 1.5 is expected to yield 16%? What’s the risk premium for the stock

Answer 1

By CAPM(Capital Asset Pricing Model) we can get the risk premium of stock  

R_j = R_f + (R_m - R_f)

Here

Rj = Reuired rate of return

Rf = Risk free rate of return

B = Risk associated

Rm = Market rte of return

Rm - Rf = Risk premium

Given :

Rj = Reuired rate of return = 16%

Rf = Risk free rate of return = 4%

B = Risk associated = 1.5

Rm = Market rte of return = ?

Rm - Rf = Risk premium =?

Solution :

R_j = R_f + (R_m - R_f)

16 = 4 + 1.5(R_m - 4)

12= 1.5 (R_m - 4)

8 = (Rm -4)

Rm = 12%

Rm - Rf = 12-4 = 8%

Hence market return = 12% while risk premium is 8%.