You consider buying a share of stock at a price of $21. The stock is expected to pay a dividend of $2.04 next year, and your advisory service tells you that you can expect to sell the stock in 1 year for $24. The stock's beta is 1.2, rf is 8%, and E[rm] = 16%. What is the stock's abnormal return?A. 1% B. 2%
C. -1%
D. -2%
E. None of the above

E. None of the above

Explanation:

First we need to calculate the holding period return

Holding period return is the rate of return which an assets earns during the period in which it holds the assets.

Holding Period Return = (Selling Price - Initial Price + Dividend ) / Initial Price

Holding Period Return = ($24 - $21 + $2.04 ) / $21 = 0.24 = 24%

Now we need to calculate the expected return on the stock using CAPM formula as follow

Expected return = Risk free rate + Beta ( Market Risk Premium )

Expected return = rf + beta ( E(rm) )

Placing values in the formula

Expected return = 8% + 1.2 ( 16% )

Expected return = 27.2%

Abnormal return is the difference of Holding period return and expected return

Abnormal return = 27.2% - 24% = 3.2%

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