The current price of a share of stock in the Down Under Clothing Company of Australia is A$50 and its expected yield over the year is 0.14. The market risk premium in Australia is 0.08 and the riskless interest rate 0.06. What would happen to the stock’s current price if its expected future payout remains constant while the covariance of its rate of return with the market portfolio falls by 50%?
Thank you
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use CAPM to find the required return, k.
since the covar with the market (its Beta) falls by 50% it must be that Beta=0.5 (the Beta of the market=1.0)
So
k=Rf +(MRP*Beta)
k=0.06 + (0.08*0.5)=0.10 or 10%
Then use the constant growth (Gordon) model to find the price
P0=D1/(k-g) where
P0=price today
D1=dividend at end of the year which is $50*0.14=7.
k=0.10
g=0 ( no growth as stated in the problem)
P0= 7./ (0.10-0)= $70
The price should go to $70
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