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Suppose a risky security pays an average cash flow of $100 in one year
Suppose a risky security pays an average cash flow of $100 in one year. The risk-free rate is 5%, and the expected return on the market index is 13%. If the returns on this security are high when the economy is strong and low when the economy is weak, but the returns vary by only half as much as the market index, then the price for this risky security is closest to:
A) $88
B) $92
C) $93
D) $95
Expert Solution
Answer: B
Explanation: B) Since the security is half as risky as the market, then the risk-premium for the security should be half of the market risk premium. The market risk premium is 13% - 5% = 8%, so the risk premium on this security should be half of this or 4%. So the expected return should be equal to the risk-free rate + the risk premium = 5% + 4% = 9%. Therefore the price = $100/1.09 = $92.
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