2) a. Stocks A and B have the following probability distributions of expected fu

Question

2)

a.

Stocks A and B have the following probability distributions of expected future returns:

Calculate the expected rate of return, rB, for Stock B (rA = 8.30%.) Do not round intermediate calculations. Round your answer to two decimal places.
%

Calculate the standard deviation of expected returns, A, for Stock A (B = 24.93%.) Do not round intermediate calculations. Round your answer to two decimal places.
%

Now calculate the coefficient of variation for Stock B. Round your answer to two decimal places.

Is it possible that most investors might regard Stock B as being less risky than Stock A?

If Stock B is less highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.

If Stock B is less highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be more risky in a portfolio sense.

If Stock B is more highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be less risky in a portfolio sense.

If Stock B is more highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.

If Stock B is more highly correlated with the market than A, then it might have the same beta as Stock A, and hence be just as risky in a portfolio sense.

b.

Suppose rRF = 8%, rM = 10%, and bi = 1.9.

2. Now suppose rRF decreases to 7%. The slope of the SML remains constant. How would this affect rM and ri?

What is ri, the required rate of return on Stock i? Round your answer to two decimal places.
%

1. Now suppose rRF increases to 9%. The slope of the SML remains constant. How would this affect rM and ri?

rM will increase by 1% and ri will remain the same.

Both rM and ri will decrease by 1%.

Both rM and ri will remain the same.

Both rM and ri will increase by 1%.

rM will remain the same and ri will increase by 1%.

-Select-IIIIIIIVVItem 2

Both rM and ri will decrease by 1%.

rM will decrease by 1% and ri will remain the same.

rM will remain the same and ri will decrease by 1%.

Both rM and ri will increase by 1%.

Both rM and ri will remain the same.

-Select-IIIIIIIVVItem 3

1. Now assume that rRF remains at 8%, but rM increases to 11%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

The new ri will be %.

2. Now assume that rRF remains at 8%, but rM falls to 9%. The slope of the SML does not remain constant. How would these changes affect ri? Round your answer to two decimal places.

The new ri will be %.

Explanation / Answer

a) Probability B Expected Return= Prob. X Return 0.2 -35.00% -7.00% 0.2 0.00% 0.00% 0.3 18.00% 5.40% 0.2 27.00% 5.40% 0.1 45.00% 4.50% Expected Return 8.30% b) Probability A Return - Expected Return (Return - Expected Return)^2 (Return - Expected Return)^2 X probability 0.2 -14.00% -22.30% 0.049729 0.0099458 0.2 3.00% -5.30% 0.002809 0.0005618 0.3 10.00% 1.70% 0.000289 0.0000867 0.2 19.00% 10.70% 0.011449 0.0022898 0.1 37.00% 28.70% 0.082369 0.0082369 Variance 0.021121 Standard Deviation=sqrt(variance) 14.53% c) Coefficient of variation = SD/Expected Return Coefficient of variation of B = 24.93%/8.30% 3.00 d) If Stock B is less highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.

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