Problem 7-12 Consider the following table, which gives a security analyst\'s exp
ID: 2651773 • Letter: P
Question
Problem 7-12
Consider the following table, which gives a security analyst's expected return on two stocks for two particular market returns:
What are the betas of the two stocks? (Round your answers to 2 decimal places.)
What is the expected rate of return on each stock if the market return is equally likely to be 7% or 15%? (Round your answers to 2 decimal places.)
If the T-bill rate is 7%, and the market return is equally likely to be 7% or 15%, what are the alphas of the two stocks? (Negative values should be indicated by a minus sign. Do not round intermediate calculations. Round your answers to 2 decimal places.)
Consider the following table, which gives a security analyst's expected return on two stocks for two particular market returns:
Explanation / Answer
The answer is as follows:
a. The Beta of the two stocks are:
Beta (A) = (2.2 - 25) / (7-15) = 2.85
Beta (B) = (5-12) / (7-15) = 0.875
b.
The expected return is computed as follows:
expected return of A = 0.5(2.2+25) = 13.6
expected return of B = 0.5(5+12) = 8.5
d.
The SML is determined by the market return of 0.5(7+15) = 11%, Beta = 1%, Risk free t bill = 7%
The aggressive stock that has fair expected return of
E(R) = 7%+2.85(11-7%) = 7+11.4 = 18.4%
The defensive stock that has fair expected return of
E(R) = 7%+0.875(11-7%) = 7+3.5 = 10.5%
Alpha A = 13.6-18.4 = -4.8
Alpha B = 8.5-10.5 = -2