Chap7_solution - Suggested Solutions to Selected Chap 7...

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Suggested Solutions to Selected Chap 7 problems Fin 367 Spring 2008 Professor Bing Han Chapter 7: 1. a, c and d. 7. a. The beta is the sensitivity of the stock's return to the market return. Call A the aggressive stock and D the defensive stock. Then beta is the change in the stock return per unit change in the market return. Therefore, we compute each stock's beta by calculating the difference in its return across the two scenarios divided by the difference in market return. 00 . 2 20 5 32 2 A = - - = β 70 . 0 20 5 14 5 . 3 D = - - = β b. With the two scenarios equal likely, the expected rate of return is an average of the two possible outcomes: E(r A ) = 0.5 × (2% + 32%) = 17% E(r B ) = 0.5 × (3.5% + 14%) = 8.75% c. The SML is determined by the following: T-bill rate = 8% with a beta equal to zero, beta for the market is 1.0, and the expected rate of return for the market is: 0.5 × (20% + 5%) = 12.5% See the following graph.
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E(r) β 8% 12.5% 1.0 2.0 A SML M .7 α D D The equation for the security market line is: E(r) = 8% + β (12.5% – 8%) d. The aggressive stock has a fair expected rate of return of:
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Chap7_solution - Suggested Solutions to Selected Chap 7...

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