Question

A stock will provide a rate of return of either −18% or 26%.

a. If both possibilities are equally likely, calculate the stock's expected return and standard deviation. (Do not round intermediate calculations. Enter your answers as a whole percent.)

b. If Treasury bills yield 4% and investors believe that the stock offers a satisfactory expected return, what must the market risk of the stock be?

Answer 1

a. Expected return = 4%

Standard deviation = 22%

b. 0%

Step-by-step explanation:

a. As the return is equally likely, the expected return which is a weighted average will be:

= (0.5 * -18%) + ( 0.5 * 26%)

= 4%

Standard deviation = √Variance

Variance = (0.5 * (-18% - 4%)²) + (0.5 * (26% - 4%)²)

= 242 + 242

= 484%

Standard deviation = √484

= 22%

b. Treasury bills have no market risk attached and the stock has an expected return that is the same as the Treasury bill yield which means that the stock therefore has no market risk.