Consider the following two scenarios for the economy and the returns in each sce

Question

Consider the following two scenarios for the economy and the returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D.

Rate of Return

21

Find the beta of each stock. (Round your answers to 2 decimal places.)

If each scenario is equally likely, find the expected rate of return on the market portfolio and on each stock. (Enter your answers as a percent rounded to 2 decimal places.)

If the T-bill rate is 5%, what does the CAPM say about the fair expected rate of return on the two stocks? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Rate of Return

Scenario Market Aggressive
Stock A Defensive
Stock D   Bust 8%     10%      6%        Boom 25        30        

21

Explanation / Answer

Scenario Market Aggressive Defensive Stock A Stock D   Bust 8%     10%      6%        Boom 25        30         21 Change in Rate   33% 40% 27% a Beta = Responsive of stock return change with respect to market return change =40%/33% =27%/33% Beta Value =                                       1.21                                          0.82 b If each situation is equally likely , then Expected return = =0.5*-8%+0.5*25% =0.5*-10%+0.5*30% =0.5*-6%+0.5*21% Expected Return value 8.50% 10.00% 7.50% c Wheb T bill rate =Risk free rate =5% Market Return expected =8.5% we can use to stock beta to use in CAPM formula of exptected stock return =Rf+(Rm-Rf)*Beta Aggressive Defensive Stock A Stock D Expected return = =5%+(8.5%-5%)*1.21 =5%+(8.5%-5%)*0.82 Expected Return Value= 9.24% 7.87%

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