Question
You have been provided the following summary of the performance of stocks A and B; of the market index; and the risk free rate. A
You have been provided the following summary of the performance of stocks A and B; of the market index; and the risk free rate.
A | B | Market Index | Risk Free Asset | |
Average annual return | 22% | 14% | 9% | 5% |
Standard deviation of annual returns | 18% | 8% | 4% | |
Correlation coefficient A and B | 0.75 | |||
Correlation coefficient A and Market | 0.35 | |||
Correlation coefficient B and Market | 0.25 | |||
Answer the followings
a. Which stock is riskier – A or B?
b. Which stock provides a higher reward to risk?
c. What is the lowest risk possible in a portfolio consisting only of A and B? What is the composition of such a portfolio?
d. Can you have a portfolio of only the Market Index and Risk Free Asset such that it has the same risk as the portfolio of A and B above? What would be the expected return of this portfolio?
e. Apply Capital Asset Pricing Model (CAPM) to estimate the expected returns of A and B. Compare it to the actual expected returns to decide if A and B are over or under priced by the stock market.
Step by Step Solution
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Step: 1
a Stock A is riskier than stock B because it has a higher standard deviation of annual returns 18 compared to 8 b To determine which stock provides a higher reward to risk we can calculate the Sharpe ...
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Corporate Finance Core Principles and Applications
Authors: Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, Bradford
3rd edition
978-0077971304, 77971302, 978-0073530680, 73530689, 978-0071221160, 71221166, 978-0077905200
