Question

3. You have $10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 21.0% and a standard deviation of 40% and T-Bills (e.g., the risk free asset) with an expected return of 5% and a standard deviation of 0%. How much money will you invest in Stock X if your goal is to create a portfolio with an expected return of 26%? The amount of money in dollars) that I will invest in Stock X is: 4. Assume that markets are efficient as defined in Chapter 12 of your book and that the Capital Asset Pricing Model (CAPM) holds. Further assume that the monthly rate of return on T-bills is 1% and that the market went up this month by 1.5%. In addition, Boomtown, Inc., which has a beta of 2, surprisingly just won a lawsuit that awards it $3 million immediately. Boomtown, Inc. is an all equity firm. If the original value of Boomtown Inc. equity were $100 million, what is the best estimate of the one month return on Boomtown stock was this month? The best estimate of the one month return on Boomtown stock this month is:

Answer 1

3. Let W be the weight of stocks in the portfolio. So, 1 - W will be the weight of T-Bills.

Expected retun on the portfolio = W * Expected return on the stocks + (1 - W) * Expected return on the T-Bills

0.26 = W * 0.21 + (1 - W) * 0.05

0.26 = 0.21W + 0.05 - 0.05W

0.26 - 0.05 = 0.16 W

W = 0.21/0.16

W = 1.3125

W = 131.25%

You need to invest 10,000 * 1.3125 = $13,125 in stock X. You will have to borrow $3,125 and invest in Stock X.

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