Consider two stocks: Stocks Current Price Possible Prices after one year Stock ABC $12.00 ABC + = $13.60 ABC – = $11.20 Stock XYZ. $10.00 ABC + = $11.75 ABC – = $8.80 Assume a risk-free borrowing and lending rate is 5.20% and that neither stock pays dividends, and fractional shares can be bought and sold. Question: 1. Do you see that there opportunity to profit in this case? If so, how can that opportunity be realized? Explain your answer 2. Suppose that you are to buy at the current price, through borrowing,1000 shares of stock ABC, and sell it short. This allows you to buy stock XYZ. You also see an opportunity to engage in the bonds market risk-free 2.a Do you think you can gain profit from this decision? 2.b If so, by how much? Show complete solution to justify your answer based on higher and a lower price after one year, for both stocks.
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 two stocks:
Stocks Current Price Possible Prices after one year
Stock ABC $12.00 ABC + = $13.60 ABC – = $11.20
Stock XYZ. $10.00 ABC + = $11.75 ABC – = $8.80
Assume a risk-free borrowing and lending rate is 5.20% and that neither stock
pays dividends, and fractional shares can be bought and sold.
Question:
1. Do you see that there opportunity to profit in this case? If so, how can that opportunity be realized? Explain your answer
2. Suppose that you are to buy at the current price, through borrowing,1000 shares of stock ABC, and sell it short. This allows you to buy stock XYZ. You also see an opportunity to engage in the bonds market risk-free
2.a Do you think you can gain profit from this decision?
2.b If so, by how much? Show complete solution to justify your answer
based on higher and a lower price after one year, for both stocks.
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