Question

Desreumaux Inc's stock has an expected return of 12.25%, a beta of 1.25, and is in equilibrium. If the risk-free rate is 5.00%, what is the market risk premium?

Answer 1

`MRP=(12.25\% -5.00\%)/(1.25)=5.8 \%`

Explanation:

Previous concepts

The Capital Asset Pricing Model (CAPM) is a concept that "analyze the relationship between risk of any type and the definition of expected return about the assets".

By definition the Market risk premium is defined as "the difference between the average return and the return on a risk-free".

The value of
`\beta` represent an adimensional number that allows to measure if we create more/low risk on any investment.

Solution to the problem

Assuming that we can use the capital asset pricing model we can calculate the market risk premium (MRP) with the following formula:

`MRP= (ER -RFR)/(\beta)`

Where:

ER= Expected return = 12.25 %

RFR= Risk free rate= 5.00%

`\beta = 1.25`

So then if we replace we got:

`MRP= (12.25\% -5.00\%)/(1.25)=5.8 \%`