Question

1) Assume that the risk-free rate is 2.9% and the market risk premium is 6.0%. What is the required rate of return on the overall stock market?

a) 8.50%
b) 8.90%
c) 9.50%
d) 10.50%
e) 11.20%
2) Assume that the risk-free rate is 3.0% and the market risk premium is 7.5%. What is the required rate of return on a stock with a beta of 0.91?
a) 7.70%
b) 8.60%
c) 9.83%
d) 10.48%
e) 12.73%

Answer 1

1) The required rate of return on the overall stock market is 8.90% (option b), and

2) the required rate of return for a stock with a beta of 0.91 is 9.83% (option c).

Step-by-step explanation:

Calculating Required Rate of Return

The first question deals with determining the required rate of return on the overall stock market, given the risk-free rate and the market risk premium. Using the formula for expected return in the Capital Asset Pricing Model (CAPM), which is:

Expected Return = Risk-Free Rate + Beta × Market Risk Premium

Since the Beta for the entire market is 1, the calculation for this scenario is straightforward:

Expected Return = 2.9% + (1 × 6.0%) = 8.9%

Therefore, the correct option for the first question is (b) 8.90%.

Calculating Stock's Required Rate of Return

The second question asks to calculate the required rate of return for a stock with a specific Beta of 0.91, given the risk-free rate and the market risk premium. Again, using the CAPM formula:

Expected Return = 3.0% + (0.91 × 7.5%)

Doing the math, Expected Return = 3.0% + 6.825% = 9.83%

Accordingly, the correct option for the second question is (c) 9.83%.