Suppose you observe the following situation Rate of Return if State Occurs State

Question

Suppose you observe the following situation Rate of Return if State Occurs State of Economy Recession Normal rrational exuberance Probability of State 0.20 0.55 0.25 Stock A -0.13 0.08 0.43 Stock B 0.08 0.23 a. Calculate the expected return on each stock. (Round the final answers to 2 decimal places.) Expected return Stock A Stock B b. Assuming the capital asset pricing model holds and stock A's beta is greater than stock B's beta by 0.65, what is the expected market risk premium (Do not round intermediate calculations. Round the final answers to 2 decimal places.) Expected market risk premium

Explanation / Answer

a). Solution :- Expected return on Stock A = 0.20 * (-) 0.13 + 0.55 * 0.08 + 0.25 * 0.43

= (-) 0.026 + 0.044 + 0.1075

= 0.1255 i.e., 12.55 %

Expected return on Stock B = 0.20 * (-) 0.11 + 0.55 * 0.08 + 0.25 * 0.23

= (-) 0.022 + 0.044 + 0.0575

= 0.0795 i.e., 7.95 %

Conclusion :-

b). Solution :-

Expected market risk premium = Difference in expected return of Stock A & Stock B / Difference in the beta of Stock A & Stock B.

= (12.55 % - 7.95 %) / 0.65

= 4.60 % / 0.65

= 7.08 % (approx).

Conclusion :- Expected market risk premium = 7.08 % (approx).

Expected return on Stock A 12.55 % Expected return on Stock B   7.95 %

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