Question

TEST QUESTIONS: IMPORTANT: SHOW YOUR DETAILED SOLUTIONS FOR EACH QUESTION. 1) You are given the following information for a security State of Economy Boom Normal Recession Probability of State of Economy 0.04 0.74 0.22 Rate of Return if State Occurs 26% 2) A stock has an expected return of 10.2 percent, the risk-free rate is 3.9 percent, and the expected return on the market is 11.10 percent a. What must the beta of this stock be? (5 points) b. Is it more or less risky than average? (5 points) c. Explain what is that the beta coefficient measures. (5 points)

Answer 1

1)

Probability	return	R*P
0.04	26	1.04
0.74	17	12.58
0.22	-44	-9.68
Total	3.94

The question doest say anything to find out Return of Portfolio = 3.94%

2)

A) Return = Rf + beta * (Rm - Rf)

10.2 = 3.9 + Beta *(11.10- 3.9)

Beta= 6.3/ 7.2 = 0.875

B) A beta of 1 indicates a security of average risk hence here it is below 1 therefore Less risky than average

C) Beta Coefficient measures the volatility of a security's return relative to the market. The larger the beta, the more volatility the security.A Beta of 1.0 indicates a security of average risk A sock with beta greater than 1.0 has above average risk, ie; its returm would be more volatile than the market return. For example market return move up by 5%a stock with a beta of 2 would find its returns moving up by 10% ( 2*5%). Similarly declaining market return by 5% would produce a decline of 10% in the return of that security.Therefore a stock with beta less than 1.0 woud have below average risk.