Stock x has a 10% expected return, a beta coefficient of .9 and a 35% standard d

Question

Stock x has a 10% expected return, a beta coefficient of .9 and a 35% standard deviation of expected returns. Stock y has a 12.5% expected return, a beta coefficient of 1.2, and a 25% standard deviation. The risk free rate is 6%, and the market risk premium is 5%.

A. Calcuate each stocks coefficient of variation?

B. Which stock is riskier for a diversified investor?

C. Calculate each stocks required rate of return?

D. On the basis of the two stocks expected and required returns which stock would be more attractive to a diversified investor?

E. Calculate the required return of a portfolio that has 7500 invested in stock x and 2500 invested in stock y?

F. If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return?

Explanation / Answer

A The coefficient of variation (CV) is defined as the ratio of the standard deviation to the mean return

Stock X = 0.35/.10 =3.5

Stock Y = 0.25/.125 =2

B Stock with higher beta would be risk in divsersified portfolio hence Stock Y has higher risk for diversified investor

C Require rate of return

= Risk ree rate + beta*( Market risk preium)

Stock X

= 6% + 0.9*5%
=10.5%

Stock Y

=6% +1.2*5%
=12%

Df the expected return using the CAPM is higher than the investor's required return, the security is undervalued and the investor should buy it.
Hence stock X is kore attractive

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