Question

Suppose you observe the following situation:

  

				Rate of Return If State Occurs
State of	Probability of
Economy	State			Stock A			Stock B
Bust		.25			?.07			?.05
Normal		.45			.14			.14
Boom		.30			.49			.29

  

a.	Calculate the expected return on each stock. (Do not round intermediate calculations. 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 .75, what is the expected market risk premium? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Expected market risk premium

%

Answer 1

a.	State of Economy	Probability (a)	Stock A (b)	Stock B ('c)	Expected Return Stock A (d=a*b)	Expected Return Stock B (e=a*c)
	Bust	0.25	-0.07	-0.05	-0.0175	-0.0125
	Normal	0.45	0.14	0.14	0.063	0.063
	Boom	0.30	0.49	0.29	0.147	0.087
					0.1925	0.1375
		Expected Return
	Stock A	19.25%
	Stock B	13.75%

b.	Assuming, CAPM holds,
	Expected Market Risk Premium =	(Stock A ER * Stock B ER )/(Stock A Beta-Stock B beta)
	=	(0.1925-0.1375)/0.75
	=	0.0733	or 7.33%