Consider the following information on Stocks I and II: Rate of Return If State O

Question

Consider the following information on Stocks I and II:

Rate of Return If State Occurs



                                              Probability of
State of Economy                 State of Economy           Stock I         Stock II
Recession                                       .45                      .05              -.18
Normal                                           .40                      .23               .14
Irrational exuberance                      .15                      .17                .23

The market risk premium is 12 percent, and the risk-free rate is 5 percent.
1(a) What is the beta of each stock? (Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places.)

                     Beta
Stock I:
Stock II:

Explanation / Answer

Expected return of Stock I = probability * return
= (0.45*5%) + (0.4*23%) + (0.15*17%)
= 14%

Expected return of Stock II = probability * return
= (0.45* -18%) + (0.4*14%) + (0.15*23%)
= 0.95%

Beta = (Expected Return - Risk free rate)/Market risk premium

Beta I = (14%-5%)/12% = 0.75

Beta II = (0.95%-5%)/12% = -0.3375 = -0.34 (rounded to 2 decimals)

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Thanks in advance :)

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