Consider the following information about Stocks A and B: The market risk premium

Question

Consider the following information about Stocks A and B:

The market risk premium is 8 percent, and the risk-free rate is 6 percent. (Round your answers to 2 decimal places. (e.g., 32.16))

The standard deviation on Stock A's return is ? percent, and the Stock A beta is? . The standard deviation on Stock B's return is? percent, and the Stock B beta is? . Therefore, based on the stock's systematic risk/beta, Stock (Click to select)BA is "riskier".

Consider the following information about Stocks A and B:

Rate of Return if State Occurs   State of Probability of   Economy State of Economy Stock A Stock B   Recession 0.25 0.08 0.23   Normal 0.45 0.20 0.10   Irrational exuberance 0.30 0.09 0.43

The market risk premium is 8 percent, and the risk-free rate is 6 percent. (Round your answers to 2 decimal places. (e.g., 32.16))

The standard deviation on Stock A's return is ? percent, and the Stock A beta is? . The standard deviation on Stock B's return is? percent, and the Stock B beta is? . Therefore, based on the stock's systematic risk/beta, Stock (Click to select)BA is "riskier".

Explanation / Answer

First calculate expected returns of both stock A and Stock B as shown in the table below

So expected return of Stock A = 13.70%

and expected return of Stock B = 11.65%

Standard deviation of A = Square root of ( 0.25* (0.08-0.137)2 + 0.45* (0.20-0.137)2 + 0.30* (0.09-0.137)2) = 5.71%

Standard deviation of B = Square root of ( 0.25* (-0.23-0.1165)2 + 0.45* (0.10-0.1165)2 + 0.30* (0.43-0.1165)2) = 24.42%

Using CAPM model, expected return can be calculated as follows

Expected return = Risk free return + Beta * market risk premium

Beta can be calculated using the above equation as folows

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

So Beta of A = (13.70% - 6%) / 8% = 0.96

So Beta of B = (11.65% - 6%) / 8% = 0.71

So since Beta of B is is lower and standard deviation of B is higher, stock B is more riskier.

Prob A B P(A) P(B) 0.25 0.08 -0.23 0.02 -0.06 0.45 0.20 0.10 0.09 0.05 0.30 0.09 0.43 0.03 0.13 0.1370 0.1165

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.