Question

Suppose you observe the following situation:

Security Beta Expected Return
Pete Corp. 1.35 .145
Repete Co. 1.04 .118

Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Expected return on market%

What is the risk-free rate? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Risk-free rate%

Answer 1

The answer is:

* Expected return on the market: 2.74%

* Risk-free rate: 11.45%

Step-by-step explanation:

Denote Rm is expected return on the market and Rf is risk-free rate. We have:

* For stock Pete: 14.5% = Rf + 1.35 x ( Rm - Rf) and

* For stock Repete: 11.8% = Rf + 1.04 x (Rm-Rf)

From the two equations above, we have: 0.31 * (Rm- Rf) = 2.7% <=> Rm - Rf = 8.71%;

So we have: 14.5% = Rf + 1.35 * 8.71% <=> Rf = 2.74%;

=> Rm = 2.7% + Rf = 8.71% + 2.74% = 11.45%.

So, Rf = 2.74%; Rm = 11.45%.