Corporate and Financial Risk Management Due: September 20, 2017 The assignment i

ID: 2819790 • Letter: C

Question

Corporate and Financial Risk Management Due: September 20, 2017 The assignment is due at the beginning of class. Late assignments will not be accepted! Please show your work to receive partial credit. You may work alone or with one other student in class. Please round only the final results to two decimal places and keep interme- diate results exact to arrive at correct solutions. 1. (9 points Capital asset pricing model) Complete the following table using the CAPM. The risk-free rate is 3%, denotes the expected return, q the volatility. A the beta factor, in the covariance with the market (in %), and pim the correlation with the market. 1 can be the market portfolio (im), stock 1 i 1) or stock 2 (i-2 Market port- 7% Stock 1 5.4% 10% 1.2 39.2 0.6 i- 2)

Explanation / Answer

1.Beta=Covariance (ri, rm)/Variance(rm)

Variance (rm)= (sm)^2

Sm=standard deviation of market reurn

2.Covariance (ri,rm)=Correlation (ri,rm) *si*sm

si=Standard Deviation of Stock (i) retrn

sm=Standard Deviation of market return

3.ri=rf+Beta(i)*(rm-rf)

rf=Risk free rate=3%

ri=Return of Stocki

rm=Return of market

Beta(i)=Beta of stock(i)

r1=5.4%

s1-10%.

Beta1=1.2

rf=3%

Using Equation 3:

5.4=3+1.2*(Rm-3)

rm-3=(5.4-3)/1.2=2%

rm=(2+3)=5%

Using Equation 1:

Beta(1)=Covariance (r1,rm)/(sm^2)

Beta(i)=1.2

Sm=7%

Covariance (r1,rm)=Beta(1)*(sm^2)=1.2*(7^2)=58.8

Beta of market=1

Correlation (r1,rm)=Covariance(r1,rm)/(s1*sm)

Covariance(r1,rm)=58.8

s1=10%

Sm=7%

Correlation (r1,rm)=58.8/(10*7)=0.84

STOCK 2:

Beta (2)=Covariance(r2,rm)/(sm^2)

Covariance (r2,rm)=39.2

Sm=7

Beta(2)=39.2/(7^2)=39.2/49=0.8

Correlation (r2,rm)=Covariance (r2,rm)/(s2*sm)

Correlation (r2,rm)=0.6

Covariance(r2,rm)=39.2

Sm=7

0.6=39.2/(s2*7)

s2=39.2/(0.6*7)=9.33%

Return of Stock 2=r2=rf+Beta(2)*(rm-rf)

r2=3+0.8*2=4.6%

Beta(i)

Covariance(ri,rm)

Correlation (ri,rm)

Market(i=m)

Stock 1(i=1)

5.40%

10%

1.2

58.8

0.84

Stock2(i=2)

4.60%

9.33%

0.8

39.2

0.6