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Q: Finance ( Answered ,   0 Comments ) Question
 Subject: Finance Category: Business and Money > Finance Asked by: victor06-ga List Price: \$10.00 Posted: 16 Oct 2006 02:45 PDT Expires: 15 Nov 2006 01:45 PST Question ID: 773983
 ```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?``` Subject: Re: Finance Answered By: livioflores-ga on 16 Oct 2006 07:00 PDT Rated: ```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```
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