You own $10,000 of Denny’s Corp stock that has a beta of 2.9. You also own $15,0

Question

You own $10,000 of Denny’s Corp stock that has a beta of 2.9. You also own $15,000 of Qwest Communications (beta = 1.5) and $5,000 of Southwest Airlines (beta = 0.7). Assume that the market return will be 11.5 percent and the risk-free rate is 4.5 percent. What is the market risk premium? Market risk premium % What is the risk premium of each stock? (Round your answers to 2 decimal places.) Denny’s risk premium % Qwest’s risk premium % Southwest Airlines risk premium % What is the risk premium of the portfolio?

Explanation / Answer

Market risk premium = 11.5% 4.5% = 7%

Denny’s risk premium = 2.9 × (11.5% 4.5%) = 20.30%

Qwest’s risk premium = 1.5 × (11.5% 4.5%) = 10.50%

Southwest Airlines risk premium = 0.7 × (11.5% 4.5%) = 4.9%

For the portfolio, determine the total value of the portfolio and the weights of each stock in theportfolio:

Total value = $10,000 + $15,000 + $5,000 = $30,000

Denny’s weight = $10,000 / $30,000 = 33.33%

Qwest’s weight = $15,000 / $30,000 = 50%

Southwest Airlines weight = $5,000 / $30,000 = 16.67%

Now compute the portfolio beta: (0.3333 × 2.9) + (0.5 × 1.5) + (0.1667 × 0.7) = 1.833

So, the portfolio’s risk premium = 1.833 × (11.5% 4.5%) = 12.83%

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