Problem #1 (8 Marks)
You are considering buying 500 shares of Gangnam Style’s common stock. The common stock is expected to pay a dividend of $4.50 a year from today; the growth rate of the dividends is 4%; the covariance between Gangnam Style’s return and the marker’s return is expected to be 0.02; the standard deviation of the market’s return is expected to be 0.1. It is also estimated that the return on the TSX/S&P is 11% and the return on government of Canada T-Bills is 6%. Should you buy the shares if the current market price of Gangnam Style’s common stock is $35.00? Show your work.
Problem #2 (4 marks)
Why are some risks diversifiable and some non-diversifiable? Give an example of each.
Problem #3 (12 marks)
a) For each of the stocks listed below, determine which are underpriced, overpriced or correctly priced if the risk-free rate of return is 3.8% and the market risk premium is 8.5%. (10 marks)
b) In an efficient market, what occurs to bring the expected return and required return back into equilibrium? (2 marks)
Stock Beta Expected Return
A .72 9.6%
B 1.04 13.1%
C 1.35 14.9%
D 1.20 14.0%
E 2 Po = $25, P1 = $28.46, D1 = $1.50
Problem #4 (14 marks)
The total value of your portfolio is $5,000: $3,000 of it is invested in Stock Y and the remainder invested in the market portfolio. The market portfolio has a beta of 1. The risk premium on the market portfolio is 8%; the risk-free rate is 2%. Additional information on Stocks A and B is provided below. (13 marks)
Return in Each State
State Probability of State Stock Y Market Portfolio
Excellent 20% 15% 15%
Normal 50% 5% 25%
Poor 30% -25% 10%
a. What are the expected returns and standard deviation of returns on Stocks Y and on the Market Portfolio? (4 marks)
b. What are the expected return and the standard deviation of your portfolio? (4 marks)
c. If the correlation between stock Y and the market portfolio is 0.5, what is the expected/required return on stock Y according to the CAPM? (4 marks)
d. What is the beta of your portfolio? (2 marks)
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