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Assume that the CAPM holds, the risk-free rate is 2% per year, the expected return on...

Assume that the CAPM holds, the risk-free rate is 2% per year, the expected return on the market is 10% per year and that the annualized volatility (standard deviation) of market returns is 20%.

Assume that the beta of IBM is 1.0, the beta of GM is 2.0, and their respective annualized return volatilities are 25% and 80%. What is the correlation between IBM and GM returns?

Group of answer choices

0.8

0.4

-0.25

0

Solutions

Expert Solution

Risk free return 2%
Market return 10%
Deviation on Market return 20%
Market return can be either 8% or 12% on apply deviation
Using CAPM expected return on IBM & GM are IBM GM
Given Beta 1 2
Expected returns under below scenario
Market rate as 10% = 2%+1*(10%-2%) = 2%+2*(10%-2%)
= 10% = 18%
Market rate as 8% = 2%+1*(8%-2%) = 2%+2*(8%-2%)
= 8% = 0.14
= 2%+1*(12%-2%) = 2%+2*(12%-2%)
Market rate as 12% = 12% = 0.22
Mean of expected return 10.00% 18.00%
Standard deviation of returns Given 25.00 0.80
COVARIANCE OF Expected return of IBM ,GM
(10-10)*(18-18)+(8-10)*(14-18)+(12-10)*(22-18)
= 16.00
CORRELATION
= COVARIANCE
SD OF IBM * SD OF GM
= 1600.00%
25%*80%
= 0.8

ekkarill92 answered 3 years ago
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