Question

Consider the following information about Stocks I and II: State of Economy Probability of  Economy Rate of...

Consider the following information about Stocks I and II:

State of Economy Probability of  Economy

Rate of Return if State Occurs

Stock I

Rate of Return if State Occurs

Stock II

Recession .26 .06 - .21
Normal .51 .18 .08
Irrational exuberance .23 .07 .41

The market risk premium is 5 percent, and the risk-free rate is 4 percent. (Do not round intermediate calculations. Enter the standard deviations as a percent and round all answers to 2 decimal places, e.g., 32.16.)

The standard deviation on Stock I's return is (a)_______ percent, and the Stock I beta is (b)_______. The standard deviation on Stock II's return is (c)_______ percent, and the Stock II beta is (d)________ . Therefore, based on the stock's systematic risk/beta, Stock (e)__________ is "riskier".

Homework Answers

Answer #1
State of Economy Probability of Economy(X) Rate of Return if State Occurs
Stock I P(I)
Rate of Return if State Occurs
Stock II P(II)
Recession 0.26 0.06 -0.21
Normal 0.51 0.18 0.08
Irrational exuberance 0.23 0.07 0.41

Expected return E(X)=sum of(x*P(X))

12.35% 8.05%
E(X^2) 0.018587 0.053393

Variance=E(X^2)-E(X)^2

0.00333475 0.04691275

Standard deviation=sqrt(Variance)

5.77% 21.66%

Expected return = risk free rate + beta * market risk premium

a) 5.77%

b)

12.35% = 4% + beta * 5%

=>

beta = 1.67

c) 21.66%

d)

8.05% = 4% + beta * 5%

=>

beta = 0.81

e)

Hence Stock I is riskier since it has high beta/systematic risk

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