The market price of a security is $34. Its expected rate of return is 18.1%. The
ID: 2775143 • Letter: T
Question
The market price of a security is $34. Its expected rate of return is 18.1%. The risk-free rate is 6% and the market risk premium is 9.6%. What will be the market price of the security if its correlation coefficient with the market portfolio doubles (and all other variables remain unchanged)? Assume that the stock is expected to pay a constant dividend in perpetuity. (Do not round intermediate calculations. Round your answer to 2 decimal places. Omit the "$" sign in your response.)
Market price____________
Explanation / Answer
We first need to calculate current Dividend:
Dividend = current price x expected return
= 34 x18.10%
= 6.154
Er = Rf +MRP x beta
Beta = (18.1%-6%)/9.6%
Beta =1.26
Doubling the correlation will also double the beta, so new beta will be
New beta = 1.26 x2 2.52
New Er = Rf +MRP x new beta
= 6% +9.6% x2.52
=30.19%
Market price = dividend/ Er
=6.154/0.3019
=20.38
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