Question

Consider the following two scenarios for the economy and the expected returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D.

Rate of Return

Scenario

Market

Aggressive Stock A

Defensive Stock D

Bust

–8

%

–10

%

–6

%

Boom

32

38

24

a. Find the beta of each stock. (Round your answers to 2 decimal places.)

b. If each scenario is equally likely, find the expected rate of return on the market portfolio and on each stock. (Enter your answers as a whole percent.)

c. If the T-bill rate is 4%, what does the CAPM say about the fair expected rate of return on the two stocks? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

d. Which stock seems to be a better buy on the basis of your answers to (a) through (c)?

• Stock D

• Stock A

Answer 1

(d)If expected return of the stock is greater than expected return as per CAPM then that stock should be bought .

Hence as we can see from above computation that Expected return of Aggresive stock which is equal to 24% is greater than return as per CAPM which is 22.72%.Therefore aggressive stock is better buy option.