Question

Suppose we had two stocks, A and B. Both are selling for $100 in the market. Stock A has an expected rate of return of 5%, while stock B has an expected rate of return for 10%.

(a) What is the expected income one would receive from holding Stock A? How about for Stock B?

(b) Given that their market prices are equal, which stock do you think incurs a greater amount of risk? Why? Suppose the market changes, such that now the perceived risks of Stock A and B are identical (but the expected income one receives from holding the stock does not change from the values you calculated in (a)).

(c) Compared to the price of Stock B, will Stock A have a lower, higher, or same price? Why?

(d) How does the expected rate of return for Stock A compare to the expected rate of return for Stock B?

(e) Suppose, after the market changes, the price of Stock B remains at $100. What is the price of Stock A?

Answer 1

Here,

Price of both stoks = $100

Return in Stock A = 5%

Return in stock B = 10%

a)

Expected value of Stock A after 1year = 100*1.05 = 105

So Return = $105-$100 = $5

Expected value of Stock B after 1year = 100*1.1 = 110

So Return = $110-$100 = $10

b)

Since higher risk entails higehr return, here stock B has higher return expectation and hence stock B is riskier

c)

If risk on both are same, return should be same. Return in B is 10% and hence retunr in A should also be 10%

Now expected value of A after 1 year = $105

So current price reduces and = 105/(1.1) = $95.45

So compared to B stock A will have a lower price

d)

Stock A expected return is lowerr as compared to stock B

e)

If after market changes stock price of B is 100 stock price of A will be $95.45 as calculated above