Answer:
Market risk premium=8%
Expected market return=9%
Explanation:
Stock A
Expected return of A=Risk free rate+ Beta(Expected market return-Risk free rate)
In the given question:
Expected return of A=5%
Beta=0.5
5%=Risk free rate+0.50((Expected market return-Risk free rate)
Let say
Risk free rate=C
Expected market return=D
5%=C+0.50(D-A)
A=5%-0.50(D-A)
A=5%-0.50D+0.50C
0.50C+0.50D=5%--------(1)
Stock B
Expected return of B=Risk free rate+ Beta(Expected market return-Risk free rate)
In the given question:
Expected return of B=13%
Beta=1.5
13%=Risk free rate+1.50((Expected market return-Risk free rate)
Let say
Risk free rate=C
Expected market return=D
13%=C+1.50(D-C)
C=13%-1.50(D-C)
C=13%-1.50D+1.50C
1.50D-1.50C+C=13%
1.50D-0.50C=13%-----------(2)
Adding equation I AND 2
0.50C+0.50D+(1.50D-0.50C)=13%+5%
0.50C+0.50D+1.50D-0.50C=18%
2D=18%
D=18/2=9%
D=9%=Expected market return
Putting the value of D in equation 2 to find value of C
0.50C+0.50D=5%
0.50C+0.50*9%=5%
0.50C=0.5%
C=1%=Risk free rate
Market risk premium=Expected market return-Risk free rate
=9%-1%
=8%
