Financial Risk Manager Part 1
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You have been provided with the following information regarding the stock of Translink, an international air transport company:
- Risk-free rate = 3%
- Expected market risk premium = 5%
- Translink beta = 1.5
Use the capital asset pricing model to determine the expected return of Translink.
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Explanation:
Explanation
According to the Capital Asset Pricing Model (CAPM), the expected return on an asset is given by:
[E(R_i) = R_f + (E(R_m) - R_f)\beta_i]
Where:
- (R_f) = Risk-free rate = 3%
- ((E(R_m) - R_f)) = Expected market risk premium = 5%
- (\beta_i) = Beta for the stock = 1.5
Substituting the values:
[E(R_i) = 3% + 5% \times 1.5] [E(R_i) = 3% + 7.5%] [E(R_i) = 10.5%]
Key Points:
- The expected market risk premium ((E(R_m) - R_f)) is already given as 5%, so we don't need to calculate it separately
- The beta of 1.5 indicates the stock is 50% more volatile than the market
- The calculation shows Translink's expected return is 10.5% to compensate for its systematic risk
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