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Two stocks: need market risk premium, fair price, portfolio weights, equilibrium expected return.

Consider two stocks, A and B, with the following expected returns and betas

Expected
Return Beta
A 9.55% 0.80
B 10.98% 1.10

The risk free rate is 5.75%

a. Assuming that Stock A is priced according to the CAPM, What is the market risk premium?

b. What is the equilibrium expected return of Stock B?

c. Consider Stock C, which has a beta of 0.90. Suppose that you have forecast a return of 8.00% for Stock C. Is Stock C is overpriced, underpriced or fairly priced?

d. Suppose that you construct an arbitrage portfolio to exploit any mispricing that you might have found in Stocks A, B and C. What would the weights of this portfolio be?

e. Suppose that the risk free rate rises by 1%. What is the equilibrium expected return of Stock A?

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Solution Summary

This solution is comprised of questions related with corporate finance. Financial management risk premiums are determined.

Solution provided by:
Jayant Kumar, MBA
Education
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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