Find a low-risk stock – Exxon Mobil or Kellog would be a good candidate. Use monthly returns for the most recent three years to confirm that the beta is less than1.0. Now estimate the annual standard deviation for the stock and the S&P index, and the correlation between the returns on the stock and the index. Forecast the expected return for the stock, assuming the CAPM holds, with a market return of 12% and a risk-free rate of 5%.
a. Plot a graph like Figure 8.5 showing the combinations of risk and return from a portfolio invested in your low-risk stock and the market. Vary the fraction invested in the stock from 0 to 100%.
b. Suppose that you can borrow or lend at 5%. Would you invest in some combination of your low-risk stock and the market, or would you simply invest in the market? Explain.
c. Suppose that you forecasted a return on the stock that is 5 percentage points higher than the CAPM return used in part (b). Redo parts (a) and (b) with the higher forecasted return.
d. Find a high-risk stock and redo parts (a) and (b).
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