Mgt201 GDB Solution

“Discussion Question”

Given a risk-free rate of 8 percent and a market risk premium of 9.5 percent, based on the betas given in the following table:

Security Beta
A 0.95

B 1.25

1. Calculate required rate of return of each stock?
2. If Ahmed is a risk lover investor, he will prefer to invest in which stock?
3. As against it, Shahzad is a risk averse investor; he will prefer to invest in which stock?

Solution:

Required rate of return for A

Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(0.95)
Rce = 0.08+(0.015)(0.95)
Rce = 0.08 + 0.01425
Rce = 0.09425 *100
Rce = 9.425%

Required rate of return for B
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(1.25)
Rce = 0.08+(0.015)(1.25)
Rce = 0.08 + 0.01875
Rce = 0.09875 *100
Rce = 9.875%

A risk loving person will buy if OR > 1 or = 1, but he might also buy when OR is < 1.
The degree of risk aversion increases as your income level falls, due to diminishing marginal
utility of income.

As Ahmad is Risk Lover he will like to invest in Stock B because it has Beta More Than 1 as 1.25

A risk averse person will not buy if OR < 1. He will also not buy if OR = 1. He might also not
decide to buy if OR > 1.

As Shahzad is risk averse so he will invest in Stock A because it has Beta Less Than 1 as 0.9