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THe risk-free rate of return is 4.5%. Expected return on market index is 7.2%. Correlation of...

THe risk-free rate of return is 4.5%. Expected return on market index is 7.2%. Correlation of stocks purchased with the market index increased from .6 to .8, and the standard deviation of the stock and market index is 25.7% and 16.4% respectively. Expected return on the stock is what?

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Answer #1

Using CAPM,

Expected Return = Rf + beta x (Rm - Rf)

where, Rf - Risk free rate = 4.5%, Rm - Market Return = 7.2%,

beta = Correlation x Std. Dev. (stock) / Std. Dev. (market) = 0.8 x 25.7% / 16.4% = 1.254

=> Expected Return = 4.5% + 1.254 x (7.2% - 4.5%) = 7.88%

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