Question 1-1 Security A has an expected return of 7%, a standard deviation of re

Question

Question 1-1

Security A has an expected return of 7%, a standard deviation of returns of 35%, a correlation coefficient with the market of -0.3, and a beta coefficient of -1.5. Security B has an expected return of 12%, a standard deviation of returns of 10%, a correlation with the market of 0.7, and a beta coefficient of 1.0. Which security is riskier? Why?

Problem 1-2

Assume the risk-free rate is 6% and that the expected return on the market is 13%. What is the required rate of return on a stock that has a beta of 0.7?

Problem 1-3

Suppose rRF = 5% rM = 10%, and rA = 12%

Calculate stock A’s beta.

If stock A’s beta were 2.0, then what would be A’s new required rate of return?

Please forgive me, I posted the first part of this question (the main body) but forgot to post the rest of the question. So here is the full question. Thank you.

Explanation / Answer

Answer:1-1 Stock A is riskier because it has a higher standard deviation (which is the industry standard for risk). That is, it has more price volatility, both in relative terms (standard deviation) and in absolute terms (standard deviation vis-a-vis expected returns). "a" is also riskier because risk can be broken into two different parts. Systemic risks and company specific risk. The systemic risk is low and the company specific risk is high on (a). The systemic risk is market risk and can be easily controlled/managed either through hedging or market-risk weighting.

Answer:1-2 Required return on the stock=Rf+Beta[ERm-Rf]

=6%+0.7[13%-6%]

=10.9%

Answer:1-3 rA = rRF + beta*(rM - rRF)

=0.12 = 0.05 + beta*(0.10 - 0.05)

0.07 = beta*(0.05) => beta = 1.4

b) If beta was 2.0 then we get rA = 0.05 + 2(0.05) = 15%

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