Question

The stock of Big Jack Co. has a beta of 1.5 and a standard deviation of 35%. The stock of Little John Co. has a beta of 0.75 and a standard deviation of 50%. If the expected return on the stock market is 9% and the T-Bill rate is 3%, which stock has a higher expected return?

By definition each stock has the same expected return; it is observed returns that differ.

Big Jack

You can’t tell without knowing the correlation of the stocks.

Little John

You can’t tell without knowing the diversifiable risk of each stock.

Answer 1

Solution) The expected return on the stock can be calculated using the Capital Asset Pricing Model (CAPM)

Expected return (Ri) = Rf + Beta*(Rm - Rf)

Rm = Market return = 9%

Rf = Risk-free rate = 3%

For Big Jack Co.:

Beta = 1.5

Expected return (Ri) = 3% + 1.5*(9% - 3%)

= 3% + 1.5*6%

= 3% + 9%

= 12%

For Little John Co.:

Beta = 0.75

Expected return (Ri) = 3% + 0.75*(9% - 3%)

= 3% + 0.75*6%

= 3% + 4.5%

= 7.5%

Thus, Big Jack Co. has higher expected return

Please comment in case of any doubts or clarifications required. Please Thumbs Up!!