EVALUATING RISK AND RETURN Stock has a 10.0% expected return, a beta coefficient
ID: 2785556 • Letter: E
Question
EVALUATING RISK AND RETURN Stock has a 10.0% expected return, a beta coefficient of 0.9, and a 35% standard deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 20.0% standard deviation. The risk-free rate is 6%, and the market risk premium is 5%. a. Calculate each stock's coefficient of variation. Round your answers to two decimal places. Do not round intermediate calculations. b. Which stock is riskier for a diversified investor? I. For diversified investors the relevant risk is measured by standard deviation of expected returns. Therefore, the stock with the higher standard II. For diversified investors the relevant risk is measured by beta. Therefore, the stock with the lower beta is more risky, Stock X has the lower III. For diversified investors the relevant risk is measured by standard deviation of expected returns. Therefore, the stock with the lower standard IV. For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher beta is less risky. Stock Y has the higher V. For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher beta is more risky. Stock Y has the higher deviation of expected returns is more risky. Stock X has the higher standard deviation so it is more risky than Stock Y. beta so it is more risky than Stock Y deviation of expected returns is more risky, Stock Y has the lower standard deviation so it is more risky than Stock X. beta so it is less risky than Stock X beta so it is more risky than Stock X c. Calculate each stock's required rate of return. Round your answers to two decimal places d. On the basis of the two stocks' expected and required returns, which stock would be more attractive to a diversified investor? e. Calculate the required return of a portfolio that has 7,000 invested in Stock X and $2,000 invested in Stock. Do not round intermediate calculations. Round your answer to two decimal places. f. If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return?Explanation / Answer
a) CVx = SDx / Rx = 35% / 10% = 3.5
CVy = 20 / 12.5 = 1.6
b) V is correct
For a diversified portfolio, relevant risk is beta. Higher beta means more risk. Hence, Stock Y is more risky than X.
c) Using CAPM,
Required rate of return = Rf + beta x MRP
For X, Rx = 6% + 0.9 x 5% = 10.50%
For Y, Ry = 6% + 1.2 x 5% = 12.00%
d) Stock Y has higher expected return than required return.
e) Rp = wx x Rx + wy x Ry = 7000 / (7000 + 2000) x 10.5% + 2000 / (7000 + 2000) x 12% = 10.83%
f) As the beta of Stock Y is higher, increase in MRP will result in larger increase in Stock Y's returns.
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