The treasury bill rate is 3% and the market portfolio return is
expected to be 12.5%. With reference to Capital Asset Pricing Model
(CAPM), answer the following :
a) What is the market risk premium? Explain the meaning of market risk
premium briefly
b) What is required rate of return on an investment which has a beta of 1.8%?
c) If the required rate of return on stock X is 12%, what is its beta?
d) If an investment with a beta of 1.2 were expected to give a return
of 14%, would you accept it?

Hi!!


a) What is the market risk premium? Explain the meaning of market risk
premium briefly

The market risk premium is the difference between the expected return
on a market portfolio and the risk-free rate. That is, for example,
the difference between the return rate of a market benchmark, like the
S&P 500, and the 10-year government bond yield.
In this case the risk free rate is the treasury bill rate, equal to
3%, and the market portfolio return is expected to be 12.5%; then:
Market Risk Premium = 12.5% - 3% = 9.5%

See for references:
"History Yields AEX Index":
"Y-aex is the weighted average of the future returns (Yields) of the
24 stocks in the Dutch AEX index."
http://www.yields.nl/history-aex.htm

AND

"Market Risk Premium":
"The Market Risk Premium is the reward-premium that investors
implicitly require for investing in a diversified portfolio of stocks
instead of risk free bonds. It is computed as the difference between
Y-aex and the yields on 10 year Dutch Treasury bonds."
http://www.yields.nl/market_risk_premium.htm



b) What is required rate of return on an investment which has a beta of 1.8%?

According to CAPM:
r = Rf + Beta * (Rm ? Rf)

where
r = the expected return on the investment
Rf = the risk-free rate
Rm = the expected return on the market portfolio
Beta = investment's beta

Then:
r = 3% + 1.8 * (12.5%-3%) = 20.1%


c) If the required rate of return on stock X is 12%, what is its beta?

According to the problem statement you know r, Rf, and Rm; so you only
need to isolate Beta:
Beta = (r - Rf) / (Rm ? Rf) = 
     = (12% - 3%) / (12.5% - 3%) =
     = 9% / 9.5% =
     = 0.947


d) If an investment with a beta of 1.2 were expected to give a return
of 14%, would you accept it?

Required rate of return = r = Rf + Beta * (Rm ? Rf) =
                            = 3% + 1.2 * (12.5% - 3%) =
                            = 14.4%

In this case the investment return is less than the required rate of
return. Hence, its NPV will be negative. You must REJECT.


I hope this helps you. Feel free to request for a clarification if you need it.


Regards,
livioflores-ga