The following information describes the expected return and risk relationship for the stocks of two of WAH’s competitors. Stock X 12.0% 20% 1.3 Stock Y 9.0 15 0.7 Market Index 10.0 12 1.0 Risk-free rate 5.0 Using only the data shown in the preceding table:
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.
The following information describes the expected return and risk relationship for the stocks of two of WAH’s competitors.
Stock X 12.0% 20% 1.3
Stock Y 9.0 15 0.7
Market Index 10.0 12 1.0
Risk-free rate 5.0
Using only the data shown in the preceding table:
- Draw and label a graph showing the security market line, and position Stocks X and Y relative to it.
- Compute the alphas both for Stock X and for Stock Y. Show your work.
- Assume that the risk-free rate increases to 7 percent, with the other data in the preceding matrix remaining unchanged. Select the stock providing the higher expected risk adjusted return and justify your selection. Show your calculations.
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