Assignment Financial Policy

Assignment 1

Question 1 (30 marks)

Stock X has an expected return of 10 percent, a beta coefficient of 0.9, and a 35 percent standard deviation of returns. Stock Y has a 12.5 percent expected return, a beta coefficient of 1.2, and a 25 percent standard deviation. The risk-free rate is 6 percent, and the market risk premium is 5 percent.

a. Calculate each stock’s coefficient of variation. Coefficient of variation: standard deviation / expected return

Stock X: 0,35 / 0,10 = 3,5

Stock Y: 0,25 / 0,125 = 2,0

b. Calculate each stock’s required rate of return.

The required return is determined by the CAPM. The formula for the capital asset pricing model is: ri = rrf + (rm – rrf)βi

If we compute the data provided with the formula, we get the following:

Stock X: rx = 6% + (5%)0,9 = 10,5%

Stock Y: ry = 6% + (5%)1,2 = 12%

c. Which stock is riskier than the other stock to a diversified investor? Explain.

The standard deviation of stock X is higher than the standard deviation of stock Y (35% > 25%), and the coefficient of variation of stock X is higher than the coefficient of stock Y (3,5 > 2,0). The higher standard deviation stands for a higher spread of possible returns, which makes the stock more riskier. The higher coefficient of variation determines how much volatility you are assuming in comparison to the amount of return you can expect from your investment. Or in other words, it is a trade-off between risk and return. The lower the coefficient, the better your trade-off between risk and return is.

d. On the basis of the two stocks’ expected and required returns, which stock would be more attractive to a diversified investor?

The expected return of stock X is 10%, while its required return is 10,5%, which means that the stock is overvalued. The opposite counts for stock Y, which is undervalued because 12% is lower than 12,5% of expected return. The conclusion is that an investor would add the stock which is undervalued,...