Question

Let θ = (rm - rf) / σm be the market risk price and θ* = (rm - rf) / σ2m = θ / σm, where σm is the standard deviation of market portfolio returns. If Pit is the price of stock i at times t = 0, 1, calculate the theoretical price Pio without subtracting the risk from the expected value E(Pi1).

Answer 1

Pio = E(Pi1) + θ(σi - σm) + θ*(rm - E(rm))

 

Where:

E(Pi1) = expected value of stock i at time t = 1

θ = (rm - rf) / σm

θ* = (rm - rf) / σ2m

σi = standard deviation of stock i

σm = standard deviation of market portfolio

rm = expected return of market portfolio

E(rm) = expected return of market portfolio