Financial Markets and Institutions
2022-2023
(1st Semester)
Department of Humanities & Social Sciences IIT, Ropar
Stock’s beta coefficient
Question :
Assuming the CAPM applies, if the market’s expected return is 13 percent, the risk-free rate is 8
percent, and stock A’s required rate of return is 16 percent, what is the stock’s beta coefficient?
Solution:
Using the capital asset pricing model (CAPM),
E(Ri) = r + βi [E(Rm) − r]
Growth Rate
Question :
The Chicago Corp stock will pay a dividend of $1.32 next year. Its current price is $24.625 per share. The beta for the
stock is 1.35 and the expected return on the market is 13.5%. If the riskless rate is 8.2%, what is the expected growth
rate of Chicago?
Solution:
Using the capital asset pricing model (CAPM),
E(Ri) = r + βi [E(Rm) − r]
We first find the expected rate of return as
E(Ri) = 0.082 + 1.35 [0.135 − 0.082] = 0.15355 = R
The expected rate of return E(Ri), for a security is also its required rate of return R by the investors.
Using the growth model for a stock, equation,
P0 = D1/ (R − g) we get,
R − g = D1/P0, or g = R − (D1/P0), which gives
g = 0.15355 − (1.32/24.625) = 0.1.
Thus the growth rate is 10%.
Price of the stock
Question :
AXN Services common stock has a β = 1.15 and it expects to pay a dividend of $1.00 after one year. Its expected
dividend growth rate is 6%. The riskless rate is currently 12%, and the expected return on the market is 18%. What
should be a fair price of this stock?
Solution:
E(Ri) = r + βi [E(Rm) − r]
we get E(Ri) = 0.12 + 1.15 [0.18 − 0.12] = 0.189
Thus, the expected return on the stock is 0.189, and the expected growth rate is 0.06 (as given).
Using P0 = D1/ (R − g) once again,
P0 = 1 0.189 − 0.06 = $7.75
Security market line
Question :
Suppose the market premium is 9%, market volatility is 30% and the risk-free rate is 3%.
(a) What is the equation of the SML?
(b) Suppose a security has a beta of 0.6. According to the CAPM, what is its expected return?
Solution:
(a) E(Ri) = r + βi [E(Rm) − r]
b) R¯ i = 0.03 + 0.09(0.6) = 8.4%.
New Share Value
Question :
The beta of Vega Lmt. is 1.15, its rate of growth is 10%, it will give a dividend of $3.00 next year, and its common stock
sells for $50 a share. The riskless rate is 8%. By careful planning and by selecting more secure projects, Vega has
reduced its risk. Its new beta is estimated to be 1, while everything else (income, dividends, growth rate, capital
structure, market return, etc.) is the same. What is its new share value?
Solution:
The total return on a stock is the sum of its dividend return and the growth rate. If r is the required rate of return, E(Ri) is the
expected rate of return, g is the growth rate, D1 is the dividend to be paid next year, and P0 is its price now, then
Thus P0 = 3/(0.1496 − 0.1) = $60.53
Question :
Consider a world with only two risky assets, A and B, and a risk-free asset. The two risky assets are in equal
supply in the market, i.e., the market portfolio M = 0.5A + 0.5B. It is known that R¯M = 11%, σA = 20%, σB =
40% and ρAB = 0.75. The risk-free rate is 2%. Assume CAPM holds. (a) What is the beta for each stock? (b)
What are the values for R¯A and R¯B?
Solution:
Beta of the stock
Question :
Eastern Oil stock currently sells at $120 a share. The stockholders expect to get a dividend of $6 next year, and they
expect that the dividend will grow at the rate of 5% per annum. The expected return on the market is 12% and the
riskless rate is 6%. This morning Eastern announced that it has won the multimillion dollar navy contract, and in
response to the news, the stock jumped to $125 a share. Find the beta of the stock before and after the
announcement.
Solution:
Using Gordon's growth model, P0 = D1/ (R − g) , we get R = D1/P0 + g, which is also the expected return on the stock,
E(R). But by CAPM, E(Ri) = r + βi [E(Rm) − r]
And β = (6/125) + 0.05 − 0.06 /(0.12 − 0.06) = 0.633, after.
Question :
Consider a world with only two risky assets, A and B, and a risk-free asset. Stock A has 200 shares outstanding, a
price per share of $3.00, an expected return of 16% and a volatility of 30%. Stock B has 300 shares outstanding, a
price per share of $4.00, an expected return of 10% and a volatility of 15%. The correlation coefficient ρAB = 0.4.
Assume CAPM holds. (a) What is expected return of the market portfolio? (b) What is volatility of the market
portfolio? (c) What is the beta of each stock? (d) What is the risk-free rate?
Solution:
