Question

e Activity: CAPM, portfolio risk, and return Consider the following information for three stocks, 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 9.02% 14 % 0.8 B 10.34 14 1.1 с 12.54 14 1.6 Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.) The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below. Open spreadsheet a. What is the market risk premium (TM - 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. % d. Would you expect the standard deviation of Fund P to be less than 14%, equal to 14%, or greater than 14%? I. less than 14% II. greater than 14% III. equal to 14% Back Next

Answer 1

Solution:

a)Calculation of market risk premium:

We can calculate the market risk premium using CAPM.As per CAPM,

Expected return=Risk free rate+Beta*Market risk premium

Using value of stock A,market risk premium is;

9.02%=5.5%+0.8*Market risk premium

Market risk premium=(9.02%-5.5%)/0.8

=4.40%

b)Calculation of Beta of fund

Beta of fund P=Sum of (Beta of particular stock*Weight of particular stock)

=0.8*1/3+1.1*1/3+1.6*1/3

=1.17

c)Calculation of expected return of fund P

Expected return of fund P=Sum of (Expected return of partcular stock*Weight of particular stock)

=9.02*1/3+10.34*1/3+12.54*1/3

=10.63%

d)Since the market is in equilibrium,hence the standard deviation of fund P shall be equal to 14%.