CAPM, portfolio risk, and return Consider the following information for three st

Question

CAPM, portfolio risk, and return

Consider the following information for three stocks, Stocks X, Y, and Z. 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 Q 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 Q? Round your answer to two decimal places.

What is the expected return of Fund Q? Round your answer to two decimal places.
%

Explanation / Answer

Part- C.

The expected return of fund Q:

Since the fund invests 1/3rd in each stoack, the epected return is :

9.60*(1/3) + 10.51*(1/3) + 12.78*(1/3) = 10.96%

Part -B:

The beta of fund Q is as follows:

0.9*(1/3) + 1.1*(1/3) + 1.6*(1/3) = 1.2

Part -A : According to the CAPM formula: Re = Rf + beta *(Rm - Rf)

where Re = 10.96% , Rf = 5.5%, beta = 1.2 and wehave to find Rm

10.96 = 5.5+1.2(Rm -5.5)

10.96 = 5.5 + 1.2Rm - 6.6

12.06 = 1.2Rm

Rm = 10.05%

Hence Market risk premium (Rm -Rf) = 10.05% -5.5% = 4.55%

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