Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a
ID: 2774823 • Letter: I
Question
Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill skiing facility that makes more money in colder years, while DS is a tour company specializing in walking tours and camping that makes more money in warmer years. Both firms are also sensitive to the business cycle. Suppose the returns on the two firms and on a diversified market portfolio (M) in different possible states of the world are as presented in the following table. Note that the returns on M are assumed not to depend on the state of the weather, so only four values have been supplied corresponding to the four possible states for the business cycle. Calculate the expected return on IS, DS and the market portfolio. Calculate the standard deviations of returns on IS, DS and the market portfolio. Calculate the CAPM beta coefficients for IS and DS. If the risk free rate were 2%, what would the beta coefficients calculated in (c) imply for the expected returns on IS and DS? Using the result in (d), deduce what the CAPM would imply about the expected return on a portfolio comprised of 30% invested in IS and 70% in DS, again assuming that the risk free rate of return is 2%. How do the expected returns implied by CAPM calculated in (d) and (e) compare with the expected returns calculated in (a)?Explanation / Answer
per the rule, i can do first four parts only.
a)
Since probability of cold and warm in each state of economy is equal, we can calculate their expected return just by averaging them. Calculation for expected return is given below:
Probability
R(IS)
R(DS)
R(M)
PxR(IS)
PxR(DS)
PxR(M)
0.1
-14.00%
-8.00%
-20.00%
-0.014
-0.008
-0.02
0.3
-10.00%
-5.00%
-5.00%
-0.03
-0.015
-0.015
0.5
34.00%
12.50%
16.00%
0.17
0.0625
0.08
0.1
26.50%
24.50%
35.00%
0.0265
0.0245
0.035
Expected return
15.25%
6.40%
8.00%
b) Calculation for standard deviation
Stock IS
Probability
R(IS)
D=R(IS)- ER(IS)
PxD^2
0.1
-14.00%
-29.25%
0.008556
0.3
-10.00%
-25.25%
0.019127
0.5
34.00%
18.75%
0.017578
0.1
26.50%
11.25%
0.001266
variance
0.046526
Standard deviation (SD) = variance ^0.50
= 0.046526^0.50
= 21.57%
Stock DS
Probability
R(DS)
D=R(DS)- ER(DS)
PxD^2
0.1
-8.00%
-14.40%
0.002074
0.3
-5.00%
-11.40%
0.003899
0.5
12.50%
6.10%
0.001861
0.1
24.50%
18.10%
0.003276
variance
0.011109
Standard Deviation = 0.011109^0.50
= 10.54%
Market portfolio
Probability
R(DS)
D=R(DS)- ER(DS)
PxD^2
0.1
-20.00%
-28.00%
0.00784
0.3
-5.00%
-13.00%
0.00507
0.5
16.00%
8.00%
0.0032
0.1
35.00%
27.00%
0.00729
variance
0.0234
Standard Deviation = 0.0234^0.50
= 15.30%
C)
Correlation coefficient between market and IS r(IS,M)=0.88
Correlation coefficient between market and DS r(DS,M)=0.98
Beta = correlation coefficient between market an stock x SD stock/ SD market
Beta (IS) = 0.88 x0.2157 /0.1530
=1.24
Beta (DS) = 0.98 x0.1054 /0.1530
=0.675
D)
Rm =8%
Rf =2%
Market risk premium MRP = 8%-2% = 6%
Er = Rf +MRP x beta
Stock IS:
15.25% = 2% + (6% x Beta)
Beta = 2.208
Stock DS:
6.40% = 2% + (6% x Beta)
Beta = 0.73
Probability
R(IS)
R(DS)
R(M)
PxR(IS)
PxR(DS)
PxR(M)
0.1
-14.00%
-8.00%
-20.00%
-0.014
-0.008
-0.02
0.3
-10.00%
-5.00%
-5.00%
-0.03
-0.015
-0.015
0.5
34.00%
12.50%
16.00%
0.17
0.0625
0.08
0.1
26.50%
24.50%
35.00%
0.0265
0.0245
0.035
Expected return
15.25%
6.40%
8.00%
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