Question

If the market risk premium is 8%, then according to the capm, the risk premium of a stock with beta value of 1.7 must be:

Answer 1

The Capital Asset Price Modeling (CAPM) gives the formula for calculating the expected return of an asset given the risk as:

Rs = Rf + β (Rm – Rf)
Where,

Rs = expected return of the financial asset

Rf = risk free rate of return

β = beta value of the asset

Rm = average return on the capital market

The factor (Rm – Rf) is also called as the market risk premium while the factor (Rs – Rf) is the stock risk premium.

Rs – Rf = β (Rm – Rf)

Rs – Rf = 1.7 (0.08)

Rs – Rf = 0.136 = 13.6%

Answer: greater than 12% (= 13.6%)