Question

The market price of a security is $27. Its expected rate of return is 13.1%. The risk-free rate is 5% and the market risk premium is 9.1%. What will be the market price of the security if its correlation coefficient with the market portfolio doubles (and all other variables remain unchanged)

Answer 1

Answer:

$16.68

Explanation:

The computation of market price is shown below:-

Current risk premium = Rate of return - Free rate

= 13.1% - 5%

= 8.1%

Current dividend = Market price × Rate of return

$27 × 13.1%

= $3.537

So, if Correlation coefficient doubles

Risk premium = Current risk premium × Correlation coefficient doubles

= 8.1% × 2

= 16.2%

Expected return = Risk premium + Free rate

16.2% + 5%

= 21.2%

Price = Current dividend ÷  Expected return

= $3.537 ÷ 21.2%

= $16.68