Question

Security Beta Expected Return Peat Co. 1.05 12.3 Re-Peat Co. 0.90 11.8 Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate?

Answer 1

Explanation:

The formula to compute the expected rate of return under the CAPM method is shown below:

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

where,

(Market rate of return - Risk-free rate of return)  is also known as market risk premium

So, the first equation is

0.123 = risk free rate of return + 1.05 × market risk premium

And, the other equation is

0.118 = risk free rate of return + 0.90 × market risk premium

Now if we equate this above equation

So,

0.005 = 0.15 × market risk premium

So, the market risk premium is

=  0.0333

Now place the market risk premium value in any of the above equation

0.123 = Risk free rate of return + 1.05 × 0.0333

So, the risk free rate of return is 8.80%

And, the expected rate of return is

= 3.33% + 8.80%

= 12.13%