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).

Please show your calculations. I need to understand it,please.

Answer #1

Solution:-

**A. To Calculate
Expected Return of Stock A-**

Expected Return is Weighted Average Return.

Expected Return = -0.15 * 0.65 + 0.13 * 0.30 + 0.20 * 0.05

**Expected Return = -4.85%**

**B. To Calculate
Expected Return of Stock B-**

Expected Return is Weighted Average Return.

Expected Return = -0.20 * 0.65 + 0.14 * 0.30 + 0.29 * 0.05

**Expected Return = -7.35%**

**C. To Calculate
Expected Market Risk Premium-**

Slope (Security Market Line) =

Slope (Security Market Line) =

**Slope (Security Market Line) = 5%**

**Expected Market Risk Premium is 5%**

If you have any query related to question then feel free to ask me in a comment.Thanks.

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