Question

Suppose you observe the following situation: Return if State Occurs Probability of State State of Economy Boom Normal Bust Stock A -.06 .15 .52 Stock B -07 .19 .74 .16 07 .33 a. Calculate the expected return on each stock. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) b. Assuming the capital asset pricing model holds and Stock A's beta is greater than Stock B's beta by 13, 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 Market risk premium b.

Answer 1

Following is the table with the calculation of expected return:

State	Probability	A	Probability weighted	B	Probability weighted
Boom	0.19	-6.00%	0.19 x-0.06=-1.14%	-7.00%	0.19 x-0.07=-1.33%
Normal	0.74	15.00%	0.74 x 0.15=11.1%	16.00%	0.74 x 0.16=11.84%
Bust	0.07	52.00%	0.07 x 0.52=3.64%	33.00%	0.07 x 0.33=2.31%
		Expected return	-1.14+11.1+3.64= 13.60%		-1.33+11.84+2.31= 12.82%

Ta=r; + Bax (rm -rf)

To=rf + Box (rm -rf)

here

• expected return of stock A

• expected return of stock B

• risk free return

• market return

13.60 = rf + Ba x rm -rf)

12.82 = r; +(Ba -0.13) x (rm -rf)

Solving

7 -16

13.60 – 12.82 = (Ba - Ba +0.13) x (rm -rf)

(rm -rf) = 6

Therefore market risk premium = 6%