Question

Based on your research, the following states of economy, probabilities of states, and returns are forecasted for Stock A and Stock B:

Return if State Occurs |
|||

State of Economy |
Probability of state |
Stock A |
Stock B |

Recession |
0.65 |
-0.15 |
-0.2 |

Normal |
0.3 |
0.13 |
0.14 |

Irrational exuberance |
0.05 |
0.2 |
0.29 |

a. What is the expected return on Stock A?

b. What is the expected return on Stock B?

c. Your research also indicates that stock A’s beta is greater than stock B’s beta by 0.5. calculate the expected market risk premium based on the Capital Asset Pricing Model (CAPM)?

d. Given that the risk-free rate is 0.5%, what is the expected return on the market based on the CAPM? (1 mark)

e. Given that the risk-free rate is 0.5%, calculate the expected return on a portfolio that has 20% invested in Stock A, 20% invested in Stock B, and the rest invested in the risk-free asset.

f. Calculate the standard deviation of returns for the portfolio in part (e).

Answer #1

Answer

Expected Return =∑( Probability * Return )

a. - 0.0485

b -0.0735

c. R a - Rb = (Beta a - beta b)* Market risk premiuim

-0.0485 - (-0.0735) = 0.5*Market rrisk premiuim

Market risk premium = 0.025 / 0.5 = 0.05

d. Rf = 0.5% beta of market will alwasys be 1, so as per capm

Rm = Rf +Beta * market risk premiuim

Rm = 0.5 +1*0.05 = 0.55

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