Question
Please give me step by step calculations so I can figure out future problems. These are practice questions. Once I have the concept then I can apply when I have an exam.
SeeBreeze Inc. has a beta of 1.0. If the expected return on the market is 15%, what is the expected return on SeeBree Inc.'s stock?
Collectibles Corp. has a beta of 3.25 and a standard deviation of returns of 27%. The return on the market portfolio is 13% and the risk free rate is 5%. What is the risk premium on the market?
Thanks for the help.
Explanation / Answer
1) According to the given problem, Beta = 1.0 Expected return on market = 15% We have to calculate the expected return on stock. To calculate this, we use the CAPM (Capital Asset Pricing Model) equation to compute the required return on stock. According to CAPM, Re = Rf + [ E(Rm) - Rf] Where Re = Required return on stock Rf = Risk-free rate = risk co-efficient = 1.0 E(Rm) = Expected market return = 15% E(Rm) - Rf = Market risk premium Substituting the values in the above equation, we get Re = Rf + 1.0 [ 0.15 - Rf] = Rf + 0.15 - Rf In the equation, both positive risk-free rate (Rf) and negative (Rf) will get cancelled and the expected return on stock will be equal to 15% which is the expected market return. 2) According to the given information, Beta = 3.25 Standard deviation = 27% Market return = 13% Risk-free rate = 5% Market risk premium is calculated as [E(Rm) - Rf] where E(Rm) = 13% Rf = 5% Substituting the values in the equation, we get E(Rm) - Rf = 0.13 - 0.05 = 0.08 or 8% Therefore, the market risk premium is 8% Where Re = Required return on stock Rf = Risk-free rate = risk co-efficient = 1.0 E(Rm) = Expected market return = 15% E(Rm) - Rf = Market risk premium Substituting the values in the above equation, we get Re = Rf + 1.0 [ 0.15 - Rf] = Rf + 0.15 - Rf In the equation, both positive risk-free rate (Rf) and negative (Rf) will get cancelled and the expected return on stock will be equal to 15% which is the expected market return. 2) According to the given information, Beta = 3.25 Standard deviation = 27% Market return = 13% Risk-free rate = 5% Beta = 3.25 Standard deviation = 27% Market return = 13% Risk-free rate = 5% Market risk premium is calculated as [E(Rm) - Rf] where E(Rm) = 13% Rf = 5% Substituting the values in the equation, we get E(Rm) - Rf = 0.13 - 0.05 = 0.08 or 8% Therefore, the market risk premium is 8%