CAPM, PORTFOLIO RISK, AND RETURN Consider the following information for stocks A

Question

CAPM, PORTFOLIO RISK, AND RETURN

Consider the following information for 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.)

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.)

What is the market risk premium (rM - rRF)? Round your answer to two decimal places.
%

What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.
%

Explanation / Answer

Solution 1:

Market risk premium = (Expected return of stock A – Risk free rate)/ Stock A’s Beta

Market risk premium = (9.18% - 5.5%)/ 0.8

Market risk premium = 4.60%

Solution 2:

Portfolio beta (P) = Stock A beta x Weight of A + Stock B beta x Weight of B + Stock C beta x Weight of C

Portfolio beta (P) = 0.8 x 1/3 + 1.2 x 1/3 + 1.7 x 1/3

Portfolio beta (P) = 1.23

Solution 3:

Portfolio Return (P) = Stock A Return x Weight of A + Stock B Return x Weight of B + Stock C Return x Weight of C

Portfolio Return (P) = 9.18% x 1/3 + 11.02% x 1/3 + 13.32% x 1/3

Portfolio Return (P) = 11.17%

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