Question

Question 3. Capital asset pricing model. (2 points) The expected return on the market portfolio is 9%. The risk free rate is 5%. The variance of the market portfolio returns is 0.08 and the covariance of the market and GE returns is 0.06. Calculate beta for GE. a) Interpret what beta means. b) Calculate the expected return for GE stock, how is it compared to the expected return on the market portfolio? c) If you form a portfolio with 75% invested in the market portfolio and 25% invested in the GE stock, what would be the expected return for the portfolio?

Answer 1

a. The beta of the stock= covariance/variance of the market
= 0.06/0.08

Beta= 0.75

Beta that is systematic risk is determined by: Rate of change of stock return to the rate of change of market return. It is the sensitivity of stock return to Market return.
Here
Beta that is systematic risk: If the rate of change of stock return is 0.75%, then the rate of change of market return is 1%.

b.
Formula:
Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)×B

Re= required rate of return.
Rf= Risk-free rate. 5%
Rm =Market Risk Premium. 9%
B = Beta, systematic risk. 0.75

Re= 5+(9-5)×0.75
Re = 8%

It is less than the expected return of the market because it has a low beta.

c.Calculation of expected return of the portfolio:

The weight in the stock Market= 0.75
The weight in the stock GE= 0.25
Expected return of stock Market = 9%
Expected return of stock GE = 8%

The expected return of the portfolio: weighted average return.
0.75 x9+0.25 x8
=8.75%