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
A
6%
B
4%
C
10%
D
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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