FIN 4663 Solutions Problems 7.7, 7.16, 7.17 and 7.18

# FIN 4663 Solutions Problems 7.7, 7.16, 7.17 and 7.18 -...

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Problem 7.7 Part (a) Notes: Beta is the sensitivity ofthe stock return to the market return therefore; Beta is the change in the return per unit change in the market return We will compute each stock's Beta by calculating the difference in its return across the two scenarios divided by the difference in the market return. Using the Aggressive (A) as an example: Beta A= Cov (RA. RM) Var (RM) A "quick and dirty way" of calculating the Betas will be: Beta A= 2-32 = 2.00 5-20 Beta 0= 3.5 -14 = 0.70 5-20 Part (b) If the two scenarios are equally likely, then the expected rate of return is the average of the two outcomes or a 50%/50% probability E(rA) = 0.5 x (2% + 32%) = 17% Mean return of A E(rD) = 0.5 x (3.5% + 14%) = 8.75% Mean return of 0 Part (c) The SML is determined by: The T-bill rate of 8% and the beta of zero; the expected rate of return for the market is 12.5% (calculated as: 0.5 x (20% +5%) = 12.5%) and the Beta 1. The equation

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FIN 4663 Solutions Problems 7.7, 7.16, 7.17 and 7.18 -...

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