You are holding a stock with a beta of 2.0 that is currently in equilibrium. The
ID: 2649381 • Letter: Y
Question
You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?
a. 36.10%
b. 38.00%
c. 40.00%
d. 42.00%
The SML relates required returns to firms
You are holding a stock with a beta of 2.0 that is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?
Explanation / Answer
1. Calculation of Present Risk Free Rate of Return:
According to CAPM:
Required Rate of Return = Rf +Beta (Rm - Rf)
Required Rate of Return = 15%, Rf = X, Rm = 10, Beta = 2
15 = X + 2 (10 - X)
X = 5 or Risk Free Rate of Return = 5%
If Required rate of Return on Average Stock increases by 30%
Stock Return = 5% + 2 x (13% - 5%)
Stock Return = 21%
So Return increase by 40% (21 - 15 = 6, 6/15 = 40%)
2. False.
Because Market risk cannot be controlled by Managerial Actions.
3. False
Because CAPM does not take into account differences in maturity.
4. c. The beta of