Question

Suppose we had two stocks, A and B. Both are selling for $10 in the market. Stock A has an expected rate of return of 2%, while stock B has an expected rate of return for 6%.

(a)What is the expected income one would receive from holding Stock A? How about for Stock B?

(b)Given that their market prices are equal, which stock do you think incurs a greater amount of risk? Why?

Suppose the market changes, such that now the perceived risks of Stock A and B are identical (but the expected income one receives from holding the stock does not change from the values you calculated in (a)).

(c)Compared to the price of Stock B, will Stock A have a lower, higher, or same price? Why?

(d)How does the expected rate of return for Stock A compare to the expected rate of return for Stock B after the change in the market?

(e)Suppose, after the market changes, the price of Stock B remains at $10. What is the price of Stock A?

Answer 1

(a)What is the expected income one would receive from holding Stock A? How about for Stock B?

Expected income = Price of stock * expected rate of return

Expected income on stock A = $10*2% = $0.20

Expected income on stock B = $10*6% = $0.60

(b)Given that their market prices are equal, which stock do you think incurs a greater amount of risk? Why?

Ans: The rule is greater risk comes with greater expected return. Since the market prices of the two stocks are equal, and stock B has a higher return (6%) vs. stock A (2%), stock B incurs a greater amoutn of risk.

Suppose the market changes, such that now the perceived risks of Stock A and B are identical (but the expected income one receives from holding the stock does not change from the values you calculated in (a)).

(c)Compared to the price of Stock B, will Stock A have a lower, higher, or same price? Why?

Ans: If perceived risks are equal and the expected incomes are teh same as earlier, i.e., $0.20 on stock A, and $0.60 on stock B, then their prices would adjust to ensure that their rate of return is also the same. Since income is higher on stock B, it will be higher priced than stock A. Hence stock A will be priced lower than B.

(d)How does the expected rate of return for Stock A compare to the expected rate of return for Stock B after the change in the market?

Ans: After the change in the market, i.e., the risks becomng equal and price adjustment between stock A and B, the rate of return on both stocks will be equal.

(e)Suppose, after the market changes, the price of Stock B remains at $10. What is the price of Stock A?

Ans: If price of stock B is $10, and income from B is $0.60, it implies a rate of return of 6%, i.e., $0.60/$10

Stock A should also give 6%, and since the income from A is $0.20, its price would be $0.20/6% = $3.33