Stock Y has a beta of 1.4 and an expected return of 16.5 percent. Stock Z has a

Question

Stock Y has a beta of 1.4 and an expected return of 16.5 percent. Stock Z has a beta of .7 and an expected return of 9.8 percent. If the risk-free rate is 5.9 percent and the market risk premium is 6.9 percent, the reward-to-risk ratios for stocks Y and Z are ? and ? percent, respectively. Since the SML reward-to-risk is ? percent

Stock Y has a beta of 1.4 and an expected return of 16.5 percent. Stock Z has a beta of .7 and an expected return of 9.8 percent. If the risk-free rate is 5.9 percent and the market risk premium is 6.9 percent, the reward-to-risk ratios for stocks Y and Z are ? and ? percent, respectively. Since the SML reward-to-risk is ? percent

Explanation / Answer

Solution:

We nned to compute the required rate of return first :

Hence using CAPM model :we will compute the SML return

Ks = Rf + beta (Market return - risk free)

for Stock A : .059 + 1.4(.069)

15.56 % = SML rate of return for stock A

The return expected is 16.5 - 5.9 = 10.6% and risk is 1.4

Hence the reward to risk ratio is nothing but the willingness to take the risk in order to get the extra return

= 10.6/1.4 = 7.57

The SML reward to risk = 15.56 - 5.9 = 9.66/1.4 = 6.9

Stock B = .059 + .7(.069)

10.73% is the SML rate of return

hence the reward to risk = 3.9/.7 = 5.57

SML reward to risk = 10.73 - 5.9 = 4.83/.7 = 6.9

thank you.

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