Question: A stock that currently trades at $10 has a beta of 1.6. The risk free interest rate for the coming year is 10 percent, and the market price of risk is (rm - rf) = 5%.
(a) What is the expected return on the stock?
(b) If the stock price is expected to remain unchanged, what would dividend payments have to be for the coming year?
(c) What stock price (P0) would you expect if dividends remain as calculated under (b) and the stock price is not expected to change during year 1 (P0 = P1)? However, the risk-free rate has dropped to 6 percent, with the market price of risk remaining unchanged?
(d) Given the conditions under (c), what stock price (P0) would you expect if the risk-free rate increased to 16 percent, with the market price of risk remaining unchanged?
(e) Generalize your findings under (c) and (d), and explain how you would expect stock prices to react to changing interest rates, other factors remaining constant.