Stock A\'s beta is 1.0 and Stock B\'s beta is 2.0. The T-bill return (a risk-fre
ID: 2726939 • Letter: S
Question
Stock A's beta is 1.0 and Stock B's beta is 2.0. The T-bill return (a risk-free rate) is 4% and the average return on the S&P 500 is 12%. Which of the following statements about the CAPM-based fair (required) returns of stocks A and B are true?
None of the above as the CAPM cannot be used to find the fair retruns for stocks with betas higher than the market beta.
The fair (required) returns of stocks A and B are 10% and 20%, respectively.
The fair (required) returns of stocks A and B are 4% and 12%, respectively.
The fair (required) returns of stocks A and B are 20% and 12%, respectively.
The fair (required) returns of stocks A and B are 12% and 20%, respectively.
1.None of the above as the CAPM cannot be used to find the fair retruns for stocks with betas higher than the market beta.
2.The fair (required) returns of stocks A and B are 10% and 20%, respectively.
3.The fair (required) returns of stocks A and B are 4% and 12%, respectively.
4.The fair (required) returns of stocks A and B are 20% and 12%, respectively.
5.The fair (required) returns of stocks A and B are 12% and 20%, respectively.
Explanation / Answer
5.The fair (required) returns of stocks A and B are 12% and 20%, respectively.
Note:
ra = rrf + Ba (rm-rrf)
where:
rrf = the rate of return for a risk-free security
rm = the broad market's expected rate of return
Ba = beta of the asset
For A:
ra = 0.04 + [1.0 * (0.12 - 0.04)] = 0.12 = 12%.
For B:
rb = 0.04 + [2.0 * (0.12 - 0.04)] = 0.20 = 20%.
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