In Chapter 7, we saw that if the market increased, the price of the bond would d
ID: 2732860 • Letter: I
Question
In Chapter 7, we saw that if the market increased, the price of the bond would decline. Applying this same logic to stocks, explain (a) how it decrease in risk aversion would affect stocks prices and earned rates of return, (b) how it would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) what the implications of this would be for the use of historical risk premiums when applying the SML equation EXPECTED RETURN A stock's returns have the following distribution: Demand for the Company's Products Probability of This Demand Occurring Rate of Return if This Demand Occurs Weak 0.1 (50%) Below average 0.2 (5) Average 0.4 16 Above average 0.2 25 Strong 0.1 60 1.0 Calculate the stock's expected return, standard deviation, and coefficient of variation. PORTFOLIO BETA An individual has $35,000 invested in a stock with a beta of 0.8 and another $40,000 invested in a stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolio's beta? REQUIRED RATE OF RETURN Assume that the risk-free rate is 6% and the required return on the market is 13%. What is the required rate of return on a stock with a beta of 0.7? EXPECTED AND REQUIRED RATES OF RETRUN Assume that the risk-free rate is 5 and the market risk premium is 6%. What is the required return for the overall stock market? What is the required rate of return on a stock with a beta of 1.2? BETA AND REQUIRED RATE OF RETRUN A stock has a required return of 11%, the risk-free rate is 7%, and the market risk premium is 4%. What is the stock's beta? If the market risk premium increased to 6%, what would happen to the stock's required rate of return? Assume that the risk-free rate and the beta remain unchanged.Explanation / Answer
Question 8.1
a. The expected return of the stock is calculated as: = 0.1*-50% + 0.2*-5% + 0.4*16%+0.2*25% +0.1*60% = 11.4%
The std.deviation and coefficient of variance is calculated as per the below table:
b. Standard deviation = 26.69%
c. Coefficeint of variance = 0.071244
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Probability - P Returns - R R - E ( R ) [R - E ( R )]^2 [R - E ( R )]^2* P 0.1 -0.5 -0.614 0.376996 0.0376996 0.2 -0.05 -0.164 0.026896 0.0053792 0.4 0.16 0.046 0.002116 0.0008464 0.2 0.25 0.136 0.018496 0.0036992 0.1 0.6 0.486 0.236196 0.0236196 Expected Return - E ( R ) 11.40% Coefficient of variance 0.071244 Std. deviation 26.69%