Question

8) Given stock X has a beta of 2 and a residual standard deviation of 22%. The market index portfolio has a standard deviation of 12%. Based on CAPM, X has an expected return of 10%,

a. Calculate the total variance of stock X.

b. Your classmate told you that you can increase stock return by holding higher residual risk. You believe you can achieve a higher rate of return by selling X and use the proceeds to buy stock Z which has the same beta but higher residual standard deviation.  Can you increase the return by holding Z if CAPM is true? (No explanation required).

Answer 1

A В C D E F Н Market portfolio 1 X 2 beta 2 3 residual standard deviation 0.22 0.12 4 expected return 0.1 6 a) 7 total variance 8 b) 0.1060 if CAPM is true, you cannot increase your return if the stock Z has the same beta 9 10 as per CAPM, higher the risk, which is Market risk (measured by beta), higher will be the expected return 11 12 13 LL

А В C Market portfolio 1 х 2 beta 2 3 residual standard deviation 0.22 0.12 4 expected return 0.1 5 6 a) 7 total variance 3[B2*B2*С3*С3)+(В3*вЗ) 8 b)