Question

Stock A has an expected return of 18.6 percent and a beta of 1.2. Stock B has an expected return of 15 percent and a beta of 0.9. Both stocks are correctly priced and lie on the Security market Line (SML). What is the reward-to-risk ratio for stock A? (6marks) (Use the simplest way to calculate)

Answer 1

Stock A

Expected return = 18.6%

Beta = 1.2

Stock B

Expected return = 15%

Beta = 0.9

Now since both the stocks lie on Security Market Line, we know as per Capital Asset Pricing Model,

Expected return of stock A = expected return of stock B

Let risk free rate be R

and Market Risk Premium = MP = Market risk (M) - Risk free

Hence,

18.6% = R + Beta x MP = R + Beta x (M - R)

0.186 = R + 1.2 x (M-R)

Similarly, for stock b

0.15 = R + 0.9 x (M-R)

solving both the equations

M = 16.2% and R = 4.2%

Now risk reward ratio of stock A = (expected return - risk free rate) / beta

= (18.6% - 4.2%) / 1.2 = 12%

This can also be solved as market return - risk free rate = 16.2% - 4.2% = 12%