34. LG U+ stock has return if the economy is in a recession? an expected return

Question

34. LG U+ stock has return if the economy is in a recession? an expected return of 11.5 percent. Given the information below, what is the expected State of Economy Probability of State of Rate of Return Recession Normal Boom 18-2 65 13 24 A. -5.72 percent B. -11.71 percent C. -11.28 percent D, 10.76 percent E. 5.72 percent 35. Which one of the following is the vertical intercept of the security market line? A. Market rate of return B. Individual security rate of return C. Market risk premium D. Individual security beta multiplied by the market risk premium E. Risk-free rate

Explanation / Answer

Question 34

Let x be the expected return if the economy is in recession.

.18x + 8.45 + 4.08 = 11.5

.18x + 12.53 = 11.5

.18x = -1.03

x = -1.03 / .18

x = -5.72%

Question 35

Security Market Line(SML) captures the relationship between beta of a stock and the required return of the stock. It help to ascertain whether the stock is giving a rate of return in line with the risk taken. We plot SML with required return on the Y axis and beta on the X axis.

Risk-free rate is the vertical intercept of the SML. When beta is zero, required return under CAPM is as follows

Rf + beta*(Rm-Rf)

Rf+0

Rf

State of economy Probability Rate of Return(%) Probability*Rate of Return Recession 0.18 x .18x Normal 0.65 13 8.45 Boom 0.17 24 4.08

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