1) Market price of the security is= $20. Its expected rate of return is= 10%. Risk free rate is= 2% and expected excess return on market portfolio is= 6%. What will be market price of security if correlation coefficient with market portfolio doubles (and all other variables remain unchanged)? Suppose that stock is expected to pay the constant dividend in perpetuity, and that CAPM holds.
To reply this problem, let us go through the steps given below.
i) Consider security before correlation coefficient doubles. Given price, expected return (discount rate) and fact that G = 0, determine the expected dividend payments for this security?
ii) What was the security’s beta before the change in the correlation coefficient?
iii) What occurs to beta when correlation coefficient doubles?
iv) What occurs to expected excess return of security? What will be the new expected total return of the security?
v) By using Gordon model, the fact which dividends are constant, and your result from part d) about expected return (that is, the discount rate), determine the new market price of security? In which direction did stock price change? describe why?