Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Rf= 2% and Rm = 12%. Using CAPM, what are the expected returns for each stock? Return of stock = Risk free rate + beta ( market rate of return - risk free rate of return) Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12% Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08% What is the expected return of an equally weighted portfolio of these two stocks? Weight of stock A = 0.50 Weight of Stock B = 0.50 Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B) = (2.12 * 0.50) + (2.08*0.50) = 1.06 + 1.04 = 3% What is the beta of an equally weighted portfolio of these two stocks? Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B) = (1.20*0.50) + (0.80*0.50) = 0.60 + 0.40 = 1 Beta of portfolio = 1 (iv) Sketch the SML to represent the market’s expected return (Please do this one) (v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please do this one)
Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Rf= 2% and Rm = 12%. Using CAPM, what are the expected returns for each stock? Return of stock = Risk free rate + beta ( market rate of return - risk free rate of return) Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12% Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08% What is the expected return of an equally weighted portfolio of these two stocks? Weight of stock A = 0.50 Weight of Stock B = 0.50 Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B) = (2.12 * 0.50) + (2.08*0.50) = 1.06 + 1.04 = 3% What is the beta of an equally weighted portfolio of these two stocks? Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B) = (1.20*0.50) + (0.80*0.50) = 0.60 + 0.40 = 1 Beta of portfolio = 1 (iv) Sketch the SML to represent the market’s expected return (Please do this one) (v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please do this one)
Chapter8: Analysis Of Risk And Return
Section: Chapter Questions
Problem 12P
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Question
- Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Rf= 2% and Rm = 12%.
- Using
CAPM , what are the expected returns for each stock?
Return of stock = Risk free rate + beta ( market
Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12%
Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08%
- What is the expected return of an equally weighted portfolio of these two stocks?
Weight of stock A = 0.50
Weight of Stock B = 0.50
Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B)
= (2.12 * 0.50) + (2.08*0.50)
= 1.06 + 1.04 = 3%
- What is the beta of an equally weighted portfolio of these two stocks?
Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B)
= (1.20*0.50) + (0.80*0.50)
= 0.60 + 0.40 = 1
Beta of portfolio = 1
(iv) Sketch the SML to represent the market’s expected return (Please do this one)
(v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please do this one)
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Question 1: An investor wants to evaluate the $2.5 million portfolio
described below:
Stock
I
II
III
IV
V
Stock's Beta Stock's Expected Return Portfolio Composition
15%
8%
16.25%
12.50%
9%
1.3
0.7
1.25
1.1
0.9
$750,000
$250,000
$500,000
$500,000
$500,000
$2,500,000
Proportions
0.30
0.10
0.20
0.20
0.20
The market rate of return is 11.5 % and the risk free rate is 5.25%.
A. Compute the expected return of the 5-asset portfolio.
B. Compute the weighted-average beta and the expected return according
to CAPM for this 5-asset portfolio.
C. Based on the above calculations, would you recommend for or against
investing in this portfolio. Briefly explain your answer.
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