Question

Expected return on two stocks for two particular market returns:

                        Market Return             Aggressive Stock        Defensive Stock

                        5%                               -2%                             6%

25%                             38%                             12%

1. What are the betas of the two stocks (Hint: compute each stock’s beta by calculating the difference in its return across the two scenarios divided by the difference in the market return)?
2. What is the expected rate of return on each stock if the market return is equally likely to be 5% or 25% (Hint: ‘equally likely’ provides the probability of each outcome)?
3. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the SML for this economy.

Answer 1