Stock x has a 10% expected return, a beta coefficient of .9 and a 35% standard d
ID: 2722396 • Letter: S
Question
Stock x has a 10% expected return, a beta coefficient of .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 25% standard deviation. The risk free rate is 6%, and the market risk premium is 5%.
A. Calcuate each stocks coefficient of variation?
B. Which stock is riskier for a diversified investor?
C. Calculate each stocks required rate of return?
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 7500 invested in stock x and 2500 invested in stock y?
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 The coefficient of variation (CV) is defined as the ratio of the standard deviation to the mean return
Stock X = 0.35/.10 =3.5
Stock Y = 0.25/.125 =2
B Stock with higher beta would be risk in divsersified portfolio hence Stock Y has higher risk for diversified investor
C Require rate of return
= Risk ree rate + beta*( Market risk preium)
Stock X
= 6% + 0.9*5%
=10.5%
Stock Y
=6% +1.2*5%
=12%
Df the expected return using the CAPM is higher than the investor's required return, the security is undervalued and the investor should buy it.
Hence stock X is kore attractive