Question

Both assets A and B plot on the SML. Asset A has an expected return of 15% and a beta of 1.7, and asset B has an expected return of 12% and a beta of 1.1. What is the risk-free rate of return?

a. 5.0%
b. 6.5%
c. 11.5%
d. It cannot be determined from this information

Answer 1

By setting up two equations based on the CAPM formula and the provided expected returns and betas for assets A and B, we solve for the risk-free rate of return, which is found to be 5.0%. The correct answer is option (A)

Step-by-step explanation:

The Security Market Line (SML) depicts the relationship between an asset's expected return and its beta with respect to the market. It is based on the Capital Asset Pricing Model (CAPM), which is defined as:

Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

Based on the information given for assets A and B, we can set up two equations using their expected returns and betas:

1. 0.15 = Risk-Free Rate + 1.7 x (Market Return - Risk-Free Rate) for Asset A

2. 0.12 = Risk-Free Rate + 1.1 x (Market Return - Risk-Free Rate) for Asset B

To find the Risk-Free Rate, we have a system of two equations with two unknowns (Risk-Free Rate and Market Return). Solving this system algebraically:

1. Isolate the Risk-Free Rate terms on one side and simplify the equations.
2. Find the value of Market Return by solving any of the equations.
3. Substitute the value of Market Return back into either equation to find the Risk-Free Rate.

After solving, we find that the risk-free rate of return is 5.0% (Option a).

Answer 2

b. 6.5%

Step-by-step explanation:

Please see attachment .