Question

The expected return on JK stock is 16.28 percent while the expected return on the market is 11.97 percent. The stock's beta is 1.63. What is the risk-free rate of return?

Answer 1

Answer:

Risk-free rate of return= 5.13%

Explanation:

The capital asset pricing model is a risk-based model. Here, the return on equity is dependent on the level of reaction of the the equity to changes in the return on a market portfolio. These changes are captured as systematic risk. The magnitude by which a stock is affected by systematic risk is measured by beta.

Under CAPM, E(r)= Rf + β(Rm-Rf)

Rf-risk-free rate (treasury bill rate), β= Beta, Rm= Return on market., E(r)- Return on equity

This model can be used to work-out the risk-free rate as follows:

E(r) = Rf + β (Rm-Rf)

Rf- ?,  β= 1.63, Rm- 11.97,  E(r)- 16.28

16.28 = Rf + 1.63× (11.97 - Rf)

16.28 = Rf + 19.5111  - 1.63Rf

collect lie terms

1.63Rf - Rf = = 19.5111- 16.28

0.63Rf = 3.2311

Divide both sides by 0.63

Rf = 3.2311 /0.63

RF = 5.128

Rf= 5.13%

Risk-free rate of return= 5.13%