Explanation:

According to the Capital Asset Pricing Model (CAPM), the expected return of a security is calculated as:

$E(R_i) = R_f + \beta_i (E(R_m) - R_f)$

Where:

• $E(R_i)$ is the expected return of the security (11%).
• $R_f$ is the risk-free rate (2%).
• $\beta_i$ is the beta of the security (1.5).
• $E(R_m) - R_f$ is the market risk premium.

Rearranging the formula to solve for the market risk premium:

$E(R_m) - R_f = \frac{E(R_i) - R_f}{\beta_i} = \frac{0.11 - 0.02}{1.5} = 0.06 = 6\%$

Thus, the market risk premium is 6%, making option B the correct answer.

Why not A or C?

• Option A (4.0%) is incorrect because it miscalculates the market risk premium by subtracting the risk-free rate again after solving for $E(R_m) - R_f$.
• Option C (7.3%) is incorrect because it uses an erroneous CAPM equation, leading to an inflated market risk premium.