Question

Stock R has a beta of 0.89, Stock S has a beta of 1.75, the expected rate of return on an average stock is 12.90%, and the risk-free rate is 6.05%. By how much does the required return on the riskier stock exceed that on the less risky stock?

Answer 1

Capital Asset Pricing Model (CAPM) is given by

Required Return = Rf + b ( Rm – Rf )

Where,

Rf – Risk free return = 6.05%

b – Beta = 0.89 for Stock R and 1.5 for Stock S

Rm – Expected return on market portfolio = 12.90%

Required Return for Stock R = 6.05 + .89 ( 12.90-6.05 )

= 6.05 + 6.0965

= 12.1465

= 12.15%

Required Return for Stock S = 6.05 + 1.75 ( 12.90-6.05 )

= 6.05 + 11.9875

= 18.0375

= 18.04%

Beta is a measure of non-diversifiablerisk (Systematic Risk). It measures the sensitivity of the stock with reference to market index. Beta of 1.75 means the stock is 75% riskier than the market. Beta of .89 indicate that the stock is 11%(100-89) less risky than the index. So in this case Stock S is riskier and Stock R is less risky.

Hence the required return on the riskier stock exceed that on the less risky stock by 5.89% (18.04 - 12.15)

answered by: anonymous