13. 10.00 points Suppose you observe the following situation: Rate of Return If

Question

13. 10.00 points Suppose you observe the following situation: Rate of Return If State Occurs State of Economy Bust Normal Boom Probability of State Stock A Stock B -.13 08 43 .20 08 .23 .25 a. Calculate the expected return on each stock. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Expected return Stock A Stock B b. Assuming the capital asset pricing model holds and Stock A's beta is greater than Stock B's beta by.65 what is the expected market risk premium? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Expected market risk premium

Explanation / Answer

A.

Expected Return on Stock = P(Bust) * E(Bust) + P(Normal) * E(Normal) + P(Boom) * E(Boom)

Here P stands for Probabilty and E stands for Return.

Entering the values we get,

Expected Return on Stock A = 0.2*(-0.13) + 0.55*0.08 + 0.25*0.43 = 12.55%

Expected Return on Stock B = 0.2*(-0.11) + 0.55*0.08 + 0.25*0.23 = 7.95%

B .

As per CAPM, the Expected Return on Stock = Risk Free Rate + Beta (Market Risk Premium)

For Stock A = Risk Free Rate + (X + 0.65) (Market Risk Premium) = 12.55%

{Where X is the Beta for Stock B}

For Stock B = Risk Free Rate + (X) (Market Risk Premium) = 7.95%

Subtract Second Equation from the First we get

0.65 Market Risk Premium = 0.046

Thus Market Risk Premium = 7.08%

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