Question

We know that two stocks A and B are correctly priced by the CAPM model. For A, the expected return is 12%, and the beta is 1.5; for B, the expected return is 6%, and the beta is 0.5. Based on this information, what is the risk free rate and equity risk premium?

Select one: A. 3%; 9%

B. 3%; 6%

C. 2%; 8%

D. 4%; 10%

Answer 1

CAPM equation for Stock A :-

12% = risk free rate + 1.5 market risk premium

let us assume risk free rate and market risk premium be the x & y resprectively.

0.12 = x + 1.5 y

-x = 1.5y - 0.12 ----------eq 1

CAPM equation for Stock B :-

6%= risk free rate + 0.5 market risk premium

0.06 = x + 0.5 y

-x = 0.5y - 0.06 -----------eq 2

if risk free rate is same for the both stocks than

1.5 y - 0.12 = 0.5y - 0.06

1y = 0.06

y = 0.06

market risk premiun = 6%

if y = 0.06 then x

-x= 1.5 y - 0.12

-x = 1.5 * 0.06 - 0.12

x = -0.09 + 0.12

x = 0.03

risk free rate = 3%

market risk premiun = 6%

so, option B is correct.