2. Use the following information to answer the questions Beta Expected return S&

Question

2. Use the following information to answer the questions Beta Expected return S&P; 500 Risk-free security Stock C Stock D 1.0 0.0 0.6 100% 50% 12.5% Figure out the market risk premium. a. b. What is the expected return on stock C? c. What is the beta for stock D? d. Total risk consists of systematic risk and unsystematic risk. i. Which risk could be eliminated by diversification strategy? Total risk, systematic or unsystematic risk? ii. Which risk will be priced? In other words, which risk will be important for your investment decision? Total risk, systematic or unsystematic risk? ii. Expected return - risk-free interest rate+* market risk premium.

Explanation / Answer

a.

Market risk premium = S&P return - Risk Free rate

= 10% - 5%

= 5%

Market risk premium is 5%.

b.

Expected return of stock C = 5% + (5% × 0.60)

= 5% + 3%

= 8%

Expected return of stock C is 8%.

c.

Beta of stock D = (12.50% - 5%) / 5%

= 7.50% / 5%

= 1.50

Beta of stock D is 1.50.

d.

(i)

Unsystematic risk is also refered as diversifiable risk. this type of risk is firm specific risk. So unsystematic risk can be reduce or eliminate by diversification.

(ii)

for making any investment decision, the investor should consider both systematic and unsystematic risk, that is total risk.

(iii)

Expected rate of return = Risk Free rate + (Beta) × Market risk premium.

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