Stock X has a beta of 0.87 and an expected return of 10.4%. Stock Y has a beta of 1.1 and an expected return of 12.2%. What is the risk-free rate of return assuming that both Stock X and Stock Y are correctly priced?
A) 2.50%
B) 4.38%
C) 3.59%
D) 3.94%
E) 3.09%

Question

Quizplus · Accepted Answer

The Capital Asset Pricing Model (CAPM) is as follows:

Expected return on a stock = Risk-free rate + beta of the stock x (Expected market return - Risk-free rate)

Using this formula for Stock X and Stock Y, we can solve for the risk-free rate:

For Stock X:

10.4% = Risk-free rate + 0.87 x (Expected market return - Risk-free rate)

For Stock Y:

12.2% = Risk-free rate + 1.1 x (Expected market return - Risk-free rate)

Solving both equations simultaneously gives us the risk-free rate of 3.59%. Therefore, the best answer choice is C).

Stock X Has a Beta of 0