Consider the following two scenarios for the economy and the expected returns in
ID: 2800420 • Letter: C
Question
Consider the following two scenarios for the economy and the expected returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D. Rate of Return Scenario Market Aggressive Stock A Defensive Stock D Bust –8 % –10 % –6 % Boom 32 38 24 a. Find the beta of each stock. (Round your answers to 2 decimal places.) b. 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 whole percent.) c. If the T-bill rate is 4%, 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.) d. Which stock seems to be a better buy on the basis of your answers to (a) through (c)? Stock D Stock A
Explanation / Answer
a) Beta = Change in Stock Price / Change in Market
Beta A = (38 - -10) / (32 - -8) = 1.20
Beta D = (24 - -6) / (32 - -8) = 0.75
b) Expected Returns, Market = (32 + -8) / 2 = 12%
Returns A = (38 + -10) / 2 = 14%
Returns D = (24 - 6) / 2 = 9%
c) Using CAPM, E(R) = Rf + beta x (Rm - Rf)
E(R) for A = 4% + 1.2 x (12% - 4%) = 13.6%
E(R) for B = 4% + 0.75 x (12% - 4%) = 10%
d) Stock A seems a better buy because its returns (14%) are higher than risk-adjusted returns of 13.6%