Question

1. Portfolio Returns. Suppose MegaChip has a beta of 1.3, whereas Littlewing stock has a beta of .7. If the risk-free interest rate is 4% and the expected return of the market portfolio is 10% according to CAPM.
   1. What is the expected return of MegaChip stock? (4 points)
   2. What is the expected return of Littlewing stock? (4 points)
   3. What is the beta of a portfolio of 60% MegaChip and 40% Littlewing stock? (4 points)
   4. What is the expected return of a portfolio of 60% MegaChip and 40% Littlewing stock? (4 points)
   5. Plot the Security Market Line and point out the market portfolio, each company’s stock, and the proposed portfolio above. (4 points)

Answer 1

CAPM = risk free rate of return (rf) + Beta*(Market return-risk free rate)

A)

rf =4% Return from market = 10% Beta = 1.3 expected return on megachip stock = 4+ 1.3*(10-4) 11.8

B)

rf -4% Return from market = 10% Beta = 0.7 expected return on Littlewings stock = 4+0.7*(10-4) 8.2

C)

Expected beta of a portfolio of 60% Megachip and 40%Littlewing stock to calculate the expected beta, we will multiply the beta with their respective weights and then add them. Megachip beta =1.3 Megachip weight = 0.6 Littlewing beta=0.7 littlewing weight = 0.4 Expected beta = 1.3*0.6+0.7*0.4 1.06

D)

Expected return of a portfolio of 60% megachip and 40% littlewings Megachip expected return = 11.8% Littlewings expected return = 8.2% expected return from the portfolio weight (Megachip)* return from Megachip + weight (littlewings) *Return from littlewings 0.6*11.8+0.4*8.2 10.36