Suppose you observe the following situation Assume these sec

Suppose you observe the following situation:

Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places. Omit the \"%\" sign in your response.)

Solution

Let Risk free rate is Rf and Return on market is Rm

Expected Return = Rf + (Rm-Rf)Beta

Peat co.:

11.6 = Rf + 1.2 Market risk premium

Re-peat co.:

9.8 = Rf + 0.7 Market risk premium

Solving both the equations,

Rf = 7.28

Market Risk premium = 3.6

Market Risk premium = Rm - Rf

3.6 = Rm - 7.28

Rm = 10.88

Thus, expected return = 10.88%

Risk-free rate = 7.28%