2. S&P; 500 free Stock C Stock D 100% 5.0% ( )% 12.5% 1.0 0.0 0.6 a. Figure out

Question

2. S&P; 500 free Stock C Stock D 100% 5.0% ( )% 12.5% 1.0 0.0 0.6 a. Figure out the market risk premium. b. What is the expected return on stock C? e. What is the beta for stock D? d. Total risk consists of systematic risk and unsystematic risk. i. Which risk could be eliminated by diversification strategy? Total risk, systematic or unsystematic risk? i Which risk will be priced? In other words, which risk will be important for your investment decision? Total risk, systematic or unsystematic risk? iii. Expected return = risk-free interest rate + ( )* market risk premium.

Explanation / Answer

a. market risk premium is the excess of market returns over and above the risk free rate of return multiplied with Beta. In the above problem statement market Beta (B) = 1; market returns (Rm)= 10%; risk free returns (Rf) = 5%

Market risk premium = B* (Rm - Rf) = 1 * (0.1 - 0.05) = 0.05

b. expected returns on Stock C

Formula to use -

E(R) of stock C = Rf + B (Rm - Rf)

Beta given for Stock C = 0.6

E(R) of stock C = 0.05 + 0.6 * (0.1 - 0.05) = 0.08 --> 8%

c) Beta of stock D

E(R) of stock D = 12.5%

0.125 = 0.05 + B * (0.1 - 0.05) = 1.5

Beta of Stock D = 1.5

d. i. Systematic risk refers to market risk which is inherent to all investments. It arises due to economic, political, social conditions of the market. This is not diversifiable risk. Unsystematic risk refers to the specific risk inherent to the stock alone - this could arise due to factors which affect the company alone - internal or external. Unsystematic risk is diversifiable risk, by adding complementary investments, one can reduce this risk.

ii. While total risk is pertinent from the perspective of choosing an investment. For assessment of a particular investment, there is not much one can determine from systematic risk, hence, in such a scenario unsystematic risk becomes pertinent. For example: while we determine if we want to invest in equity or debt (asset class), we look at total risk and choose according to our risk appetite. Incase, we have chose to invest in equity stocks, then when assessing Stock A vs. Stock B we would particularly look at unsystematic risk.

iii. Expected return = Risk free interest rate + Beta * (Market returns - risk free interest rate)

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