If Stock A's beta was 2.0, what would be A's new required rate of return?
Assume that the risk-free rate designated by r RF = 5%, the market risk premium designated by r M = 10%, and the expected rate of return for stock A is designated by r A = 12%
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The beta of a stock gives the volatility of returns of the stock compared to the returns of the benchmark used to estimate volatility. Stocks with a high value of beta are high-risk, high-return options; compared to the benchmark they give higher gains as well as higher losses. Low beta stocks are less volatile with their returns but they have a lower magnitude as compared to the benchmark.
Stock A has a beta of 2.0. The required rate of return from stock A is higher than that of the return from the market if the market return is positive. The return rA that is related to beta by:
beta = (rA - rF)/(rM - rF)
As rF = 5% and rM = 10% and beta = 2
2 = (rA - 5)/(10 - 5)
10 = rA - 5
=> rA = 15%
The required rate of return from stick A is 15%.
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