Question

stock A has a beta of 0.5 and investors expect it to return 5%. on the other hand, stock B has a beta of 1.5 and investors expect it to return 10% use the CAPM to find:

1.The market risk premium

2.The Expected rate of return on the market.

Answer 1

stock A return is=risk free rate+beta*The market risk premium

5%=risk free rate+0.5*The market risk premium (equation 1)

stock B return is=risk free rate+beta*The market risk premium

10%=risk free rate+1.5*The market risk premium (equation 2)

subtract equation 1 from equation 2

(10%-5%)=(risk free rate-risk free rate)+(1.5-0.5)*The market risk premium

5%=1.0*The market risk premium

The market risk premium=5%/1.0=5%

now put this in equation 1

5%=risk free rate+0.5*5%

risk free rate=2.5%

The Expected rate of return on the market=The market risk premium+risk free rate=5%+2.5%=7.5%

the above is answer..