Financial Risk Manager Part 1

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What is the market risk premium if the expected return on a stock is 12% while its beta is 1.5? Assume the risk-free rate is 6% and the return on the market is 10%.

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TTanishq

10%

12%

Explanation:

Explanation

Using the Capital Asset Pricing Model (CAPM):

Formula: Expected return on stock = Risk-free rate + Beta × (Market return - Risk-free rate)

Given:

Expected return on stock = 12%
Risk-free rate = 6%
Beta = 1.5
Market return = 10%

Calculation: $12\% = 6\% + 1.5 \times (10\% - 6\%)$ $12\% = 6\% + 1.5 \times 4\%$ $12\% = 6\% + 6\%$ $12\% = 12\%$ ✓

The market risk premium is defined as: $\text{Market Risk Premium} = \text{Market Return} - \text{Risk-free Rate}$ $\text{Market Risk Premium} = 10\% - 6\% = 4\%$

Therefore, the market risk premium is 4%, which corresponds to option B.

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