Beta Expected return S&P 500 Risk-free security Stock C Stock D 1.0 0.0 0.6 ( )

Question

Beta

Expected return

S&P 500

Risk-free security

Stock C

Stock D

1.0

0.0

0.6

(     )

10.0%

5.0%

(    )%

12.5%

1. Figure out the market risk premium.

2.What is the expected return on stock C?

3. What is the beta for stock D?

4.Total risk consists of systematic risk and unsystematic risk.

a.Which risk could be eliminated by diversification strategy? Total risk, systematic or unsystematic risk?

b.Which risk will be priced? In other words, which risk will be important for your investment decision? Total risk, systematic or unsystematic risk?

c.Expected return = risk-free interest rate + (         )* market risk premium.

Beta

Expected return

S&P 500

Risk-free security

Stock C

Stock D

1.0

0.0

0.6

(     )

10.0%

5.0%

(    )%

12.5%

Explanation / Answer

According to Capital Asset Pricing Model, the expected return is calculated as

E(R) = Rf+ Beta(Rm-Rf)

Rf is the risk free rate of return

Beta is the volatility of stock

Rm-Rf denotes the risk premium

E(R) Shows the expected rate of return

Ste 1p

A)Market Risk Premium

Expected return of market portfolio = 10%

Risk free rate of return = 5%

Formula for calculating market risk premium = (Rm-Rf)Beta

E(R) = Rf+ Beta(Rm-Rf)

10% = 5%+(Rm-Rf) Market Beta = 1

10% = 5%+(Rm-Rf) 1

= 5%

Market risk premium is the difference between the Expected return of market portfolio and the risk free rate of return.

B)Calculate expected return for Stock C

= 5%+(10%-5%)0.6

= 0.05+(0.05).6

= 0.08 = 8%

The expected return of stock c = 8%

C) Beta for Stock D;

E(R) = Rf+ Beta(Rm-Rf)

=12.5% = 5%+x (10%-5%)

=12.5% - 5% = x (5%)

=7.5%= x (5%)

Beta for Stock D = 1.5

4)Unsystematic risk or idiosyncratic risk can be diverfied away by using effective portfolio strategy

Systematic risk is the most important risk which can not be elimated by portfolio strategies. A thorough and care ful examination is needed before making any investment decision in the stock market.

Expected Return = Risk free interest rate+ (Beta)* Market Risk Premium

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.