Question

Suppose you observe the following situation:

State of Probability of Return if State Occurs
Economy State Stock A Stock B
Boom .18 ? .06 ? .07
Normal .73 .15 .16
Bust .09 .51 .32

a. Calculate the expected return on each stock. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Expected return
Stock A %
Stock B %

b. Assuming the capital asset pricing model holds and Stock A’s beta is greater than Stock B’s beta by .24, what is the expected market risk premium? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Market risk premium             %

Answer 1

a)	Expeted Return = Sum( Prob x Return)
	Economy	Prob.	A	B	Prob x Return (For A)	Prob x Return (For B)
	Boom	0.18	6.00%	7.00%	1.08%	1.26%
	Normal	0.73	15.00%	16.00%	10.95%	11.68%
	Bust	0.09	51.00%	32.00%	4.59%	2.88%
					16.62%	15.82%
	Expected Return
	A	16.62%
	B	15.82%
b)	As per CAPM =
	Re =	Rf + (Rm-Rf) x Beta
	A =	16.62%	= Rf + (Rm-Rf) x B
	B =	15.82%	= Rf + (Rm-Rf) x (B-0.24)
		(-)	(-)
		0.80%	=(Rm-Rf)(B-(B-0.24))
		0.80%	=(Rm-Rf)(0.24)
		Rm- Rf =	0.033333
		Rm- Rf =	3.333%