Question

P5.17 Referring to ProDIe be altered? Explain. G3 GR P5.18 A security has a beta of 1.2. Is this security more or less risky than the market? Explain Assess the impact on the required return of this security in each of the following cases a. The market return increases by 15%. b. The market return decreases by 8%. c. The market return remains unchanged.

Answer 1

As the beta of this stock is 1.2 ,this stock is more risky than the market.

As the beta becomes greater than 1 ,which is the market beta the riskiness of the stock increases.

If the beta is less than 1,then the stock is less risky than the market.

The required return of a stock can be computed by the CAPM model as ,

Re = Rf + beta( Rm - RF)

As the return on the market increases ,the required return increases .

Suppose, the return on the market is 5% and the risk free rate is 3%.

The required return will be :

= 3 + (5- 3) *1.2

= 5.4%

If the return on the market increases by 15%,

Re = 3 + (5.75 - 3) 1.2

= 6.3%

So, the required return increases by ,

= 16.67%

As the return on the market decreases ,the required return also decreases.

Similarly ,

The required return decreases by ,

Re = 3 + ( 4.6 - 3)1.2

= 4.92

So, the required return decreases by ,

= 8.89%

As the return on the market does not change ,the required return also does not change.