Stock A has a beta of .6, and investors expect it to return 5%. Stock B has a be

Question

Stock A has a beta of .6, and investors expect it to return 5%. Stock B has a beta of 1.4, and investors expect it to return 7%. Use the CAPM to find the expected rate of return on market and the market risk premium. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

Please show all work

Stock A has a beta of .6, and investors expect it to return 5%. Stock B has a beta of 1.4, and investors expect it to return 7%. Use the CAPM to find the expected rate of return on market and the market risk premium. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

Please show all work

Explanation / Answer

Using CAPM model,

Expected return = Risk free return + (Beta*Market risk premium)

For stock A,

0.05 = Risk free return + (0.6*Market risk premium)

Risk free return = 0.05 - (0.6*Market risk premium)

For stock B,

0.07 = Risk free return + (1.4*Market risk premium)

Risk free return = 0.07 - (1.4*Market risk premium)

Comparing both equations,

0.05 - (0.6*Market risk premium) = 0.07 - (1.4*Market risk premium)

Market risk premium = 0.02 / 0.8 = 0.025 = 2.5%

Risk free return = 0.07 - (1.4*Market risk premium) = 0.07 - (1.4*0.025) = 0.105 = 10.5%

Expected return on market = Risk free return + Market risk premium = 2.5% + 10.5% = 13%

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