You are holding a stock with a beta of 2.0 that is currently in equilibrium. The

Question

You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?

      a. 36.10%
       b. 38.00%
       c. 40.00%
       d. 42.00%

The SML relates required returns to firms

You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?

Explanation / Answer

1. Calculation of Present Risk Free Rate of Return:

According to CAPM:

Required Rate of Return = Rf +Beta (Rm - Rf)

Required Rate of Return = 15%, Rf = X, Rm = 10, Beta = 2

15 = X + 2 (10 - X)

X = 5 or Risk Free Rate of Return = 5%

If Required rate of Return on Average Stock increases by 30%

Stock Return = 5% + 2 x (13% - 5%)

Stock Return = 21%

So Return increase by 40% (21 - 15 = 6, 6/15 = 40%)

2. False.

Because Market risk cannot be controlled by Managerial Actions.

3. False

Because CAPM does not take into account differences in maturity.

4. c. The beta of

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