Question

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0; and the market risk premium, rM − rRF, is positive. Which of the following statements is CORRECT?a. Stock B's required rate of return is twice that of Stock A.b. If Stock A's required return is 11%, then the market risk premium is 5%.c. If Stock B's required return is 11%, then the market risk premium is 5%.d. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock B's.e. If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's.

Answer 1

Answer:

b. If Stock A's required return is 11%, then the market risk premium is 5%

Explanation:

Let's analyze each choice with the CAPM formula; r= risk free+beta(mrkt return - risk free)

a.)

Assume market return is 8%

rA= 6% +1 (8% - 6%)= 8%

rB= 6% +2 (8% - 6%)= 10%

Since stock B's return is not twice that of stock A, choice a.) statement is WRONG.

b.)

Formula ; r= risk free+beta(mrkt return - risk free)

Find MRP if rA=11% knowing that MRP = (mrkt rate - risk free)

11% = 6% +1 (11% - 6%)

Therefore MRP= 11%-6% = 5% making choice b. CORRECT