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Suppose that you are considering investing in two stocks for one year: Stock A and Stock B
Suppose that you are considering investing in two stocks for one year: Stock A and Stock B. The current price of stock A is $60 and analysts forecast a price of $80 in one year if the economy is booming, or $50 if the economy enters a recession. The current price of Stock B is $30 and analysts forecasts a price of $36 in one year if the economy is booming and a price of $32 if the economy is in a recession. You believe that the probabilities of a recession is 40% and boom is 60%. Stocks A and B do not pay dividends. (*** SHOW your work for partial credit. Please copy the cells from a spreadsheet and paste them into the box, OR type in your calculations directly. DO NOT upload pictures of your spreadsheet or your notes. Emailing them *does not count for partial credit.) a) Calculate the expected return for each stock based on these forecasts and report your results. (only answers inside the box count) b) Suppose that you decide to invest $40,000 in stock A and $160,000 in stock B. Find the expected return and standard deviation of the portfolio. (only answers inside the box count)
Expert Solution
A.) Stock A Expected return = (Chances of recession * profit/loss in recession + Chances of boom * Profit/loss in boom)/ Stock Price * 100
= (0.40 * -10 + 0.60*20)/60*100
Stock A Expected return = 13.33%
Stock B Expected return = (Chances of recession * profit/loss in recession + Chances of boom * Profit/loss in boom)/ Stock Price * 100
= (0.40 * 2 + 0.60*6)/30*100
Stock B Expected return = 14.67%
B.) Stock A = $ 40,000
Stock B =$ 160,000
| Stocks | Amount invested | Weight |
| A | 40000 | 20% |
| B | 160000 | 80% |
Return of the portfolio = Weight of stock A * Return of stock A+Weight of stock B * Return of stock B
= 20% * 13.33% + 80% * 14.67%
= 14.396%
C.) Stock A =
Risk free rate = 1.5%
Beta =1.5
Expected return market = 12%
Expected return = 1.5% + (1.5*(12%-1.5%))
= 17.25%
Stock B =
Risk free rate = 1.5%
Beta =1.1
Expected return market = 12%
Expected return = 1.5% + (1.1*(12%-1.5%))
= 13.05%
D.)
| Stock | CAPM Return | Analyst prediction |
| A | 17.25% | 13.33% |
| B | 13.05% | 14.67% |
Stock A is Undervalued as it has more potential than analyst predicted whereas Stock B is slightly Overvalued as according to CAPM it is giving less return.
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