Question

Suppose you observe the following situation: State of Economy Bust Normal Boom Probability of State .15 .60 Return if State Occurs Stock A Stock B -.08 -10 .11 .09 .27 .25 .30 a. Calculate the expected return on each stock. (Do not round interme calculations and enter your answers as a percent rounded to 2 decimal places 32.16.) b. Assuming the capital asset pricing model holds and Stock A's beta is greater thar Stock B's beta by .30, what is the expected market risk premium? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Stock A Stock B b. Slope of SML

Answer 1

a). Expected Return = [Probability(i) * Return(i)]

=1

Stock A's Expected Return = [0.15 * -8%] + [0.60 * 11%] + [0.25 * 30%]

= -1.2% + 6.6% + 7.5% = 12.90%

Stock B's Expected Return = [0.15 * -10%] + [0.60 * 9%] + [0.25 * 27%]

= -1.5% + 5.4% + 6.75% = 10.65%

b). Slope_SML = Increase in expected return / Increase in beta

= [12.90% - 10.65%] / 0.30 = 2.25% / 0.30 = 7.50%

Since the market’s beta is 1 and the risk-free rate has a beta of zero, the slope of the Security Market Line equals the expected market risk premium. So, the expected market risk premium must be 7.50%