Question

Stock R has a beta of 2.3, Stock S has a beta of 0.55, the required return on an average stock is 10%, and the risk-free rate of return is 6%. By how much does the required return on the riskier stock exceed the required return on the less risky stock? Round your answer to two decimal places.

Answer 1

Let's start solving by recalling the Capital Assets Pricing Model(CAPM). According to CAPM, the required return can be calculated by:

Risk-Free Rate + Beta * Risk Premium

Now, Picking up the riskier stock whose beta is 2.3 and Risk Premium, which is the difference between the stock return and risk-free return ie. 4% (10% - 6%) In this case,

Required Rate of Return = 6% + 2.3 * 4%

Required rate of Return = 6% + 9.2% = 15.2%

The same formula can be used to calculate the required rate of return of less risky stock like this.

Required Rate of Return = 6% + 0.55 * 4% (This time, beta has changed to 0.55)

Required Rate of Return = 6% + 2.2%

Required Rate of Return = 8.2%

As stated in the above calculations, the required return on the riskier stock exceeds the required return on the less risky stock by 7% (15.2% - 8.2%).