What is the expected return for the overall stock market and the required rate of return for a stock that has a beta of 1.2 if the risk-free rate is 5% and the market risk premium is 6%.

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justaguide eNotes educator| Certified Educator

The risk free rate of return refers to the rate of return offered by an asset where the volatility of the rate of return is 0. Examples of this include treasury bonds and securities issued by the government where there is no chance of a default.

Returns from investments made in the stock market involve a certain amount of risk, there is a possibility that the returns could be lower. To compensate for the risk a market risk premium is applied. As the market risk premium is 6% and the risk free rate of return is 5%, the expected rate of return from the stock market is 5 + 6 = 11%.

A stock with a beta of 1.2 has a required rate of return equal to R where beta = (R - Rf)/(Rm - Rf), Rm is the rate of return of the market and Rf is the risk-free rate of return

Here R = 1.2*6 + 5 = 12.2%. The required rate of return of the stock is 12.2%