Question

The projected rate of return on stocks A and B are 13% and 18%, respectively. Their standard deviations are 11% and 9% respectively. Stock A has beta of 0.5 and Stock B has beta of 1.5. The T-bill rate and the expected rate of return on the S&P/TSX index are 6% and 16%,respectively. If you currently hold a well-diversified passive index portfolio, would you buy any of the two stocks? If yes, which one?

Answer 1

Expected Rae of Return of Stock A is = 13%

While Required Rate of Return is = Rf + β(rm- Rf) _ _ _ _ _ _ (Using Capital Asset Pricing Model)

Where Rf is the risk free rate of return

Rm is the market Return

β is the beta of the Stock

While Required Rate of Return is = 6% + 0.5(16%-6%)

= 6% + 5%

= 11%

Expected Rate of Return > Required Rate of Return

13% > 11%

NOW

Expected Rae of Return of Stock B is = 18%

While Required Rate of Return is = Rf + β(rm- Rf) _ _ _ _ _ _ (Using Capital Asset Pricing Model)

Where Rf is the risk free rate of return

Rm is the market Return

β is the beta of the Stock

While Required Rate of Return is = 6% + 1.5(16%-6%)

= 6% + 15%

= 21%

Expected Rate of Return < Required Rate of Return

18% < 21%

I would like to buy Stock A because WE are getting Expected Return which is more than the required Rate of Return

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