Question

The risk-free rate is 5%; Stock A has a beta of 2.0; Stock B has a beta of 1.0; and the market risk premiumis positive. Which of the following statements is CORRECT?

A) 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.
B) If Stock A's required return is 11%, then the market risk premium is 6%.
C)If Stock B's required return is 11%, then the market risk premium is 6%.
D) Stock A's required rate of return is twice that of Stock B

Answer 1

Answer:

C) If Stock B's required return is 11%, then the market risk premium is 6%.

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

The (Market rate of return - Risk-free rate of return)  is also known as the market risk premium

If we take the required return is 11%, so the market risk premium would be for stock B

11% = 5% + 1 × Market risk premium

11% - 5% = Market risk premium

So, the market risk premium would be 6%

If we take the required return is 11%, so the market risk premium would be for stock A

11% = 5% + 2 × Market risk premium

11% - 5% = Market risk premium

So, the market risk premium would be 3%

Hence, the correct option is C