Question

Which of the following statements are correct?
a. Stock A has an expected return of 10% and a standard deviation of 15%, and stock B has an
expected return of 13% and a standard deviation of 14%. No investor would ever buy stock A
because it has a lower expected return and a higher risk than stock B.
b. A firm is expected to pay a dividend of £3 per share in one year. This dividend is expected to grow
at a rate of 7% forever. If the current market price for a share is £67, the company’s cost of equity
is higher than 11%.
c. A 10-year bond has an annual coupon rate of 6% and face value of £100. The bond pays
semi-annual coupons. If the yield to maturity on the bond is 10% per year, the price of the
bond must be below par.
d. A higher yield to maturity implies that a bond’s expected return is higher.

Answer 1

a) Stock A has an expected return of 10% and a standard deviation of 15%

stock B has an expected return of 13% and a standard deviation of 14%

Since StockA has lower return and higher risk , so ideally no investor would buy it as it doesn't lie on the efficient frontier

hence this statement is correct

b) Dividend in Year 1 = 3

Growth rate = 7%

Current price of share acc to dividend growth model = Dividend in Year 1 / (cost of equity - Growth rate)

or, 67 = 3/ (cost of equity - 0.07)

Cost of equity = 0.1147 or 11.47%

hence this statement is correct

c) When the coupon rate is below the YTM , the bond trades below par or at a discount.

hence this statement is correct

d) There are other risks like default risk on which the bond's expected return depends. So A higher yield to maturity implies that a bond’s expected return is higher is not necessarily true.

hence this statement is not correct