The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0,

Question

The risk-free rate is 6%; Stock A has a beta of 1.0; Stock B has a beta of 2.0, and the market risk premium, rM - rRF, is positive. Which of the following statements is correct? Stock B's required rate of return is twice that of Stock A. If Stock A's required return is 11%, the market risk premium is 5%. If Stock B's required return is 11%, the market risk premium is 5%. If the risk-free rate increases but the market risk premium stays unchanged, Stock B's required return will increase by more than Stock A's. If the risk-free rate remains constant but the market risk premium increases, Stock A's required return will increase by more than Stock A's.

Explanation / Answer

Correct answer is: If Stock A’s required return is 11%, then the market risk premium is 5%. According to formal CAPM: r=r[f]+ß(r[m]-r[f]) r[f]=6 ß[a]=1 r[a]=6+(r[m]-r[f]) 11=6+(r[m]-r[f]) (r[m]-r[f])=11-6=5

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