Question

The expected return on the market portfolio equals 10%, the beta for Stock K equals 1.10, and the expected return on the stock equals 10.6875%. Calculate the risk free rate. (Enter percentages as decimals and round to 4 decimals)

Answer #1

Beta of stock = 1.10, Expected return on market = 10% and Expected return on stock = 10.6875%

We know that according to Capital Asset Pricing Model

Expected return on stock = Risk free rate + Beta of stock x (Expected return on Market portfolio - risk free rate)

10.6875% = Risk free rate + 1.10 x (10% - risk free rate)

10.6875% = Risk free rate + 11% - 1.10 x risk free rate

1.10 Risk free rate - Risk free rate = 11% - 10.6875%

0.10 Risk free rate = 0.3125%

Risk free rate = 0.3125% / 0.10 = 0.003125 / 0.10 =0.03125 = 3.1250%

Therefore risk free rate = 3.1250%

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