Question

Suppose you observe the following situation: State of Economy Probability of State of Economy Rate of Return if State Occurs Stock A Stock B Boom .21 .189 .097 Normal .74 .158 .076 Recession .05 - .246 .042 Assume the capital asset pricing model holds and Stock A's beta is greater than Stock B's beta by .84. What is the expected market risk premium?

A. 10.06 percent
B. 8.28 percent
C. 7.81 percent
D. 9.05 percent
E. 7.94 percent

Answer 1

Answer:

C. 7.81%

Explanation:

Stock A and Stock B expected Return shall be calculated using the following formula:

Stock A/B expected return=Probability@Boom*Return at Boom+Probability@Normal*Return at Normal+Probability@Recession*Return at Recession.

Stock A return=0.21*18.9%+0.74*15.8%+0.05*-24.6%

                       =14.43%

Stock B return=0.21*9.7%+0.74*7.6%+0.05*4.2%

                       =7.87%

Market risk premium=(Stock A Return- Stock B return)/0.84

Market risk premium=(14.43%-7.87%)/0.84=7.81%

So Based on the above explanation, the answer shall be C. 7.81%