Background: The paper describes the relationship between risk and expected return and determination of risk free rate in valuation of a stock. In a stock pricing we find that expected return of a stock is the sum of risk-free government bill rate and risk premium. If this expected return does not fulfill the required return, then the investment should be taken carefully considering the growth potentiality of the stock.
Findings: We can compute the expected return using the ACI stock price and DSE all share price index. If the average risk-free rate of 91-day government Treasury bill is 7 percent, the beta (risk measure derived from regression) of the stock is 1.14 and the average expected market return over the period is calculated as 10 percent, the stock expected return is 10.42 percent (7 percent +1.14(10 percent -7 percent)). Here the risk premium is 3.42 percent.
Methods: In evaluating the ACI stock we have used the OLS method considering the unit ischolar_main and other tests of signification. The time path of risk free rate is impacted by trend, seasonality, cycle and irregularities. BB prudently maintains the inflation rate among others through risk free rate using its instruments.
Application/Improvements: Risk free rate has role to calculate the value of a stock and maintaining inflation and GDP growth. This paper analyzes the risk free rate, risk premium and related variables to evaluate the stock in order to maintain financial stability.