Q2

A. A stock has a current market price of $40. Its expected yearly net return is Eri = 13%. The stock pays no dividends next year. The risk free net return is instead rf = 7%, and the market risk premium, ErM rf = 8%. Suppose the expected price for the stock for next year remains constant but the covariance of its return with the market return doubles. How will the current price change?

B. Consider two securities with the following expected returns and betas: Er1 = 6%, Er2 = 12%; 1 = 0:5; 2 = 1:5. Suppose their prices are consistent with the Security Market Line (SML).

a. Compute the equation for the SML;

b. Suppose two new securities, X and Y , are issued. And suppose their betas are X = 0:5 and Y = 2. What returns would you expect for these two securities?

c. Suppose the expected return of security X is 8%. What would you expect investors to do in the market and how would this aect the security price?