Question

Please show all work and formula:

Please use the information on the table below to answer this question.

Security                       Actual Return             Beta

A                                 12%                             1.2

B                                  10%                             1.0

C                                  14%                             1.4

1. Assume the risk-free interest rate is 1% and the market risk premium is 5.5%. An investor would like to invest $40,000 in Security A, $25,000 in security B and $50,000 in Security C. Find the portfolio’s expected return.
2. Find the portfolio’s actual return.
3. Based on your answers to a and b, is the portfolio’s return higher or lower than required? How should prices react?

Answer 1

Answer a:

Let us first calculate Portfolio Beta:

Risk-free interest rate is = 1%

Market risk premium is = 5.5%

Portfolio’s expected return = Risk free rate + Portfolio beta * Market risk premium = 1% + 1.243 * 5.5% = 7.84%

Portfolio’s expected return = 7.84%

Answer b:

Portfolio's Actual Return = 12.43%

Working:

Answer c:

From part a above: Portfolio’s expected/required return = 7.84%

From part b above: Portfolio's Actual Return = 12.43%

Hence:

Portfolio’s actual return higher than required.

Prices are expected to decrease.