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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: Tbill 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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View Full DocumentE(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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 Spring '08
 han

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