Stock Question.........?

Question

From what you might know about the current risk-free rate and historic risk premium, can someone develop a required return for the average stock in the U.S. Stock Market, and dscuss the reasoning for each of the required return factors.

Answer 1

Take a pencil and pen and draw the following. X and Y axis. Mark Y axis Ks the return on security and Y axis beta the risk. Slightly above the origin draw a second order curve. Draw a tangent to it and let it meet the Y axis at Krf which is the risk free rate. At the tangent to the curve draw a vertical line to meet the x axis and call it beta=1 and another horizontal line which meet Y axis and call it Km the market return. Now you are all set for the derivation.
Ks the stock return for the expected risk beta= d krf x beta/dx = krf x d beta/dx + beta dkrf/dx=
=krf x 1 + beta (km -krf)/1=
=krf +beta(km - krf).
1 comes where beta = 1 the risk for market stocks. km - krf/1 = dkrf/dx.
This is the derviation for required rate of return. The reason for it is the required stock return is equal to risk free rate which is the systematic risk or risk inherent in the economy plus risk premium for the non systematic risk meassued as difference between market risk and risk free return multiplied by beta. beta is the percentage change in stock price to percentage change in Marke index. Beyond this it is slightly complicated to explain. I think it suffices. Only thing I abstain from is a method to calculate beta, which usually can be found in publications about stocks. It is slightly complicated involving some statistics. So I abstain. FYI:The second order curve you drawn is called the 'efficient frontier' and the slanting line is called the 'security market line'. Efficient frontier is on which all the returns of the companies fall. The return increases as risk increases and then falls for higher risk which is the practical case and the security market line is drawn for messuring the increased return requiref for increased risk.

Answer 2

Homework question, right?

First, understand that nothing is risk free. Even government bonds carry SOME risk, albeit small.

Most people cite 10% as the historic yearly increase in the market, when you average across the history.