You live in a world where assets are priced by the CAPM. The following information is given to you regarding stock X. The expected payoff from the stock X=£105.00 Expected return of stock X = 18% Risk-free rate =5% Market Risk Premium = 9% Assume there are no other changes, except that the correlation between the returns of Stock X and the market becomes twice what it is currently. How would this change affect the current price of Stock X? Explain why the change of the correlation causes the observed change in the stock price. [hint: Provide a risk-based explanation]
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.
- You live in a world where assets are priced by the
CAPM . The following information is given to you regarding stock X.
The expected payoff from the stock X=£105.00
Expected return of stock X = 18%
Risk-free rate =5%
Market Risk Premium = 9%
Assume there are no other changes, except that the correlation between the returns of Stock X and the market becomes twice what it is currently.
- How would this change affect the current price of Stock X?
- Explain why the change of the correlation causes the observed change in the stock price. [hint: Provide a risk-based explanation]
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