Question

A stock with a beta of 2.0 has an expected rate of return of 21%. If the market return this year turns out to be 8 percentage points below expectations, what is your best guess as to the rate of return on the stock

Answer 1

The answer is 5%

Step-by-step explanation:

Solution

Given that:

A stock with a beta =2.0

The expected rate of return =21%

Market return turnout = 8%

Now,

Rf = risk free return

Rp = risk premium =Rm -Rf

β = 2.0

Thus

The expected return R = Rf +β *Rp

= Rf +β * (Rm -Rf)

R = Rf +2.0 (Rm -Rf)

=Rf + 2 times risk premium

So,

The market turns by 8%

R = Rf +2.0 (Rm -8%-Rf)

=Rf + 2 Rm-16%-2Rf

Then

The expected return is reduced by 16%

Hence,

21% -16% =5%

Therefore the expected rate of return on the stock is 5%