Question

(4) Suppose you observe the following situation: Security Beta Expected Return Pete Corp. 1.15 12.90% Repete Co. 0.84 10.20% Assume the two securities are correctly priced. Based on CAPM, what is the expected return on the market? What is the risk-free rate?

Answer 1

Based on CAPM,

Expected rate of return = Risk free rate + Beta * Market risk premium

For Pete Corp, 12.90% = Rf + 1.15 * MRP ------> Equation 1

For Repete Corp, 10.20% = Rf + 0.84 * MRP ------> Equation 2

Equation 1 - Equation 2

2.70% = (1.15 * MRP) - (0.84 * MRP)

2.70% = 0.31 * MRP

MRP = 8.71%

For Equation 1,

12.90% = Rf + 1.15 * 8.71%

Rf = 2.8839%

Risk free rate = 2.88%

Market Risk Premium = Expected Market Return - Risk Free Rate

8.71% = Expected Market Return - 2.88%

Expected Market Return = 11.59%