Question

Suppose you observe the following situation:

  

				Rate of Return if State Occurs
State of	Probability of
Economy	State			Stock A			Stock B
Bust		.20		–	.06		–	.04
Normal		.60			.15			.15
Boom		.20			.50			.30

  

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 .47, 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.)

Expected market risk premium

%

Answer 1

(a)-Expected return on each stock

Expected return
Stock A	17.80%
Stock B	14.20%

Expected return on Stock A

Expected return on Stock A = (-6% x 0.20) + (15% x 0.60) + (50% x 0.20)

= -1.20% + 9% + 10%

= 17.80%

Expected return on Stock B

Expected return on Stock B = (-4% x 0.20) + (15% x 0.60) + (30% x 0.20)

= -0.80% + 9% + 6%

= 14.20%

(b)-Expected market risk premium

Market Risk Premium = [Expected return of stock A - Expected return of stock B) / Change in Beta of the stock

= (17.80% - 14.20%) / 0.47

= 3.60% / 0.47

= 7.66%

“Therefore, the Expected market risk premium would be 7.66%”