Question

The risk-free rate of return is 4%, and the market return is 10%. The betas of Stocks A, B, C, D, and E are 0.85, 0.75, 1.20, 1.35, and 0.5 respectively. The expected rates of return for Stocks A, B, C, D, and E are 7%, 9%, 9.5%, 12.1%, and 14% respectively. Which of the above stocks would an investor be indifferent towards buying or selling?

Answer 1

Answer:

Security D

Explanation:

Fair rate of Return  = $R_{f} \ +\ B( R_{m}\ -\ R_{f} )$

where B  = Beta, which is the degree of responsiveness of security return to market return

$R_{f}$ = Risk Free Rate of return

$R_{m}$ = Return on market portfolio

$R_{m}\ - \ R_{f} =$ Risk premium which is, 10 - 4 = 6 %

Thus, for security A = 4 + 0.85 × 6 = 9.1%

         for security B = 4 + 0.75 × 6=  8.5%

         for security C = 4 + 1.2 × 6 = 11.2%

         for security D = 4 + 1.35 × 6 = 12.1%

         for security E = 4 + 0.5 × 6 = 7%

Expected returns as given  

     for A = 7%

     for B = 9%

     for C = 9.5%

    for D = 12.1%

     for E = 14%

As is evident, the fair and expected return for stock D is the same i.e 12.1%. Hence, the investor would be indifferent in that case whether to buy, sell or hold such a stock.