Question

CAPM, PORTFOLIO RISK, AND RETURN Consider the following information for stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.) Stock Expected Return Standard Deviation Beta A 8.74% 16% 0.9 B 9.57 16 1.1 C 11.64 16 1.6 Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium. (That is, required returns equal expected returns.) a. What is the market risk premium (rM - PRF)? Round your answer to two decimal places. % b. What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places. c. What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places. %

Answer 1

The required rate of return R(e) is calculated by CAPM model

R(e) = r(f) + Beta*(R(m) - r(f))

a) For Stock A

0.0874 = 0.05+0.9*Market risk premium

Market risk premium = 0.04155 = 4.16%

b) Beta of fund P = Summation of {Probability*Beta}

Beta of fund P = (1/3)*0.9+ (1/3)*1.1+ (1/3)*1.6 = 1.20

c) Required return = r(f) + Beta*(R(m) - r(f))

Required return = 0.05+1.20*0.04155 = 0.0999

Required return = 9.99%