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%

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