Question

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 Standard Deviation 14% 14 14 Beta 0.9 1.3 1.7 Expected Return 9.60 % 11.42 13.24 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.) a. What is the market risk premium (rM TRF)? 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% 11. greater than 14% 111, equal to 14% -Select-

Answer 1

a

Using stock A data

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

9.6 = 5.5 + 0.9 * (Market risk premium%)

Market risk premium% = 4.56

b

Weight of A = 0.3333

Weight of B = 0.3333

Weight of C = 0.3333

Beta of Fund P = Weight of A*Beta of A+Weight of B*Beta of B+Weight of C*Beta of C

Beta of Fund P = 0.9*0.3333+1.3*0.3333+1.7*0.3333

Beta of Fund P = 1.30

c

Weight of A = 0.3333

Weight of B = 0.3333

Weight of C = 0.3333

Beta of Fund P = Weight of A*Beta of A+Weight of B*Beta of B+Weight of C*Beta of C

Beta of Fund P = 9.6*0.3333+11.42*0.3333+13.24*0.3333

Beta of Fund P = 11.42

d

Due to diversification benefits, as std dev of all stocks is equal to 14% and they are not perfectly correlated, std dev of fund P will be less than 14%