The capital asset pricing model is r = rF + β(rM ? rF) Where: r = investors' required rate of return rF = the risk-free rate β = the individual stock's beta rM = the expected return to the market The expected market risk premium is (rM ? rF), or the expected return to the market minus the risk-free rate. We know the risk-free rate is .03, but we do not yet know the expected return to the market. The first step in solving this is to calculate rM, and the second step is to subtract .03, the rF given in the problem, from the calculated rM to find the expected market risk premium. Putting the numbers we know into the CAPM, we solve for rM: .074 = .03 + 1.4(rM ? .03) Steps to solve this using algebra are: 1. Simplify the right side of the equation by performing the multiplication: .074 = .03 + 1.4rM ? .042 2. Combine like terms on the right side of the equation: .074 = 1.4rM ? .012 3. Add .012 to both sides of the equation: .086 = 1.4r M 4. Divide both sides of the equation by 1.4 to calculate the value of rM: rM = .0614 Finally, subtract .03, the risk-free rate, from .0614, the expected return to the market, to calculate the expected market risk premium: .0614 ? .03 = .0314
This is the expected return to the market. It is not the expected market risk premium. The expected market risk premium is the expected return to the market minus the risk-free rate.
This is the expected return of Investment A divided by the beta of investment A, plus the risk-free rate. This is not the correct use of the capital asset pricing model. The capital asset pricing model is r = rF + β(rM ? rF) Where: r = investors' required rate of return rF = the risk-free rate β = the individual stock's beta rM = the expected return to the market The expected market risk premium is (rM ? rF), or the expected return to the market minus the risk-free rate. We know the risk-free rate is .03, but we do not yet know the expected return to the market. The first step in solving this is to calculate rM using the information given in the problem, and the second step is to subtract .03, the rF given in the problem, from the calculated rM to find the expected market risk premium.
This is the sum of the risk-free rate and the expected return on Investment A divided by the beta of Investment A. This is not the correct use of the capital asset pricing model. The capital asset pricing model is r = rF + β(rM ? rF) Where: r = investors' required rate of return rF = the risk-free rate β = the individual stock's beta rM = the expected return to the market The expected market risk premium is (rM ? rF), or the expected return to the market minus the risk-free rate. We know the risk-free rate is .03, but we do not yet know the expected return to the market. The first step in solving this is to calculate rM using the information given in the problem, and the second step is to subtract .03, the rF given in the problem, from the calculated rM to find the expected market risk premium.
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