Question

Assume that Treasury bills are generating a return of 5% and the return on the Wilshire 5000 stock index is 12%. Satellite Systems Inc. (SSI) returns are 20% less volatile than the overall market. What rate of return would an investor look for when deciding to invest in SSI?

Answer 1

Treasury bills are risk-free assets. Hence, treasury bill return is equivalent to Risk-free rate i.e., R_f = 5%

Return on the Wilshire 5000 stock index = Market return = R_m= 12%

We know that the beta of a stock (β_i) is the measure of its volatility with respect to the market. It is given that, SSI returns are 20% less volatile than the overall market which means that the beta of the SSI stock = 1 - 20% = 0.8, [β_i = 0.8]

We need to calculate the rate of return on SSI i.e., R_i

CAPM Equation

R_i = R_f + β_i * (R_m - R_f) = 5% + 0.8*(12% - 5%) = 5% + 5.6% = 10.6%

Answer -> 10.6%