Question

Use a risk-free rate of 1% and a market return of 6% for the following question. What is the expected return for a stock with a beta of 1.25 and what is the market risk premium?

Answer 1

We require to Calculate expected return and we have risk-free rate, market return and beta so we can calculate expected return using the CAPM model.

Expected Return = Rf + β (Rm - Rf)

Where:

Rf = Risk-free rate,

β = Beta of underlying asset,

Rm = Market return

Expected Return = 1% + 1.25 (6% - 1%)

= 1% + 1.25 x 5%

= 1% + 6.25%

= 7.25%

So expected return is 7.25%

Market risk premium means excess return of market return over risk-free rate.

Market risk premium = Rm - Rf = 6% - 1% = 5%

Market risk premium is 5%.