Consider the following data for two risk factors (1 and 2) and two securities (J and L): λ0 = 0.07 λ1 = 0.04 λ2 = 0.06 bJ1 = 0.10 bJ2 = 1.60 bL1 = 1.80 bL2 = 2.45 a. Compute the expected returns for both securities. b. Suppose that Security J is currently priced at $50 while the price of Security L is $15.00. Further, it is expected that both securities will pay a dividend of $0.95 during the coming year. What is the expected price of each security one year from now? c. Compute the correlation between stock A and stock B considering the following data. Standard deviation of stock A = 10 percent Standard deviation of stock B = 17 percent Covariance between the two stocks = 90.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Consider the following data for two risk factors (1 and 2) and two securities (J and L):
λ0 = 0.07 λ1 = 0.04 λ2 = 0.06
bJ1 = 0.10 bJ2 = 1.60 bL1 = 1.80 bL2 = 2.45
a. Compute the expected returns for both securities.
b. Suppose that Security J is currently priced at $50 while the price of Security L is $15.00.
Further, it is expected that both securities will pay a dividend of $0.95 during the coming year.
What is the expected price of each security one year from now?
c. Compute the correlation between stock A and stock B considering the following data.
Standard deviation of stock A = 10 percent
Standard deviation of stock B = 17 percent
Covariance between the two stocks = 90.
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