You plan to invest in a Hedge Fund, which has total capital of $500 million inve

Question

You plan to invest in a Hedge Fund, which has total capital of $500 million invested in 5 stocks:

Stock         Investment        Beta

A                 $140mil             0.5

B                  120mil              2.0

C                  100mil              4.0

D                   80 mil              1.0

E                   60 mil               3.0

The risk free rate is 4.87% and you believe the following probability distribution for future market returns is realistic:

Probability           Market Return

0.1                           4%

0.2                           5

0.4                           7

0.2                           9

0.1                          10

What is the market required return of the fun portfolio?

Explanation / Answer

First, we need to calculate portfolio beta which is calculated as follows:

Hence porfolio beta is 1.94

Now we need to calculate market return which is as follows:

7%

Hence the market return Rm = 7%

Risk Free return Rf = 4.87%

Portfolio Beta is 1.94

Hence required return of portfolio as per CAPM is given as Rf + beta*(Rm-Rf) = 4.87 + 1.94*(7-4.87) = 9%

Hence market required return on the portfolio is 9%

Stock Investment Proportion of Investment Beta Weighted average beta A 140 0.28 0.5 0.14 B 120 0.24 2 0.48 C 100 0.2 4 0.8 D 80 0.16 1 0.16 E 60 0.12 3 0.36 500 1.94

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