Question

using the stocks from above question 3

Stock A o (in %) 20 B 0.5 3. The risk-free rate is 0% and the expected return on the market is 10%. You are given the same stocks as in Q 2. Assuming, as in Q 2(b), that you hold the stock as part of a well-diversified portfolio, which stocks would you buy if the expected return on the stocks were as below: Stock Expected return in % MOA co

Answer 1

2 a) If stocks need to be hold individually , the required rate shall be directly related to the total risk (Standard deviation) of the stock Hence, since A has the highest standard deviation, we would require the highest return from A

So, the stocks in increasing order of expected return is

Stock D (least expected return), Stock C, Stock B, Stock A (highest expected return)

b) If stocks are held as a part of large , well diversified portfolio, we would only worry about systematic risk( beta) and required rate should also be related to beta . Hence, since D has the highest beta, we would require the highest return from D.

So, the stocks in increasing order of expected return is

Stock C (least expected return), Stock A, Stock B, Stock D (highest expected return)

3. The required rate of return from each stock can be calculated from CAPM

R_A = Risk free rate + beta_A (market return- risk free rate)

= 0+0.5 * (10-0) =5%

R_B = Risk free rate + beta_B (market return- risk free rate)

= 0+1 * (10-0) =10%

R_C = Risk free rate + beta_C (market return- risk free rate)

= 0- 0.5 * (10-0) = - 5%

R_D = Risk free rate + beta_D (market return- risk free rate)

= 0+2 * (10-0) =20%

The alpha of the stock can be measured by the difference between expected return and required return

Alpha = Expected return - required return

So, Alpha (A) = 5% -5% =0%

  Alpha (B) = 12% -10% =2%

Alpha (C) = 0% - (-5%) =5%

Alpha (D) = 15% -20% =-5%

We will only hold the stocks with positive alpha ie. Stocks B and C