Question 12 q SEai We have the following CAPM E(Ri) 06+.08 Beta; a) If Stock X h

Question

Question 12 q SEai We have the following CAPM E(Ri) 06+.08 Beta; a) If Stock X has a beta of 2, what is the required rate of return? b) If we form a portfolio that is invested 40% in Stock X and 60% in the risk free asset, what i; c) the expected rate of return on that portfolio? What is the beta of that portfolio? Stock Z has a beta of 1.5 Andan expected return of 15%. Is at a good buy? d)Construct a portfolio of Stock X and the risk free asset which has a beta of 1.5. e) What is the expected return for this purpose?

Explanation / Answer

A)The required return if Beta is 2 = 0.06+0.08*2 =0.22

B)Here Rf = 0.06

Expected return of the portfolio = 0.4*22% + 0.6*6% =12.4%

since beta of Rf = 0,the expected beta = 0.4*2 = 0.8

C)Beta is nothing but systematic risk of a security in comparing to the market.in this case stock z havibg beta of 1.5 which is lessthan beta of stockX i.e 2. and expected return is 15%.so stockz is offering lower return at lower risk.If the investor is a risk averse its a good buy.

D)let W be portion of stock X.

Then w*2 + (1-w)*0 = 1.5

W = 1.5/2 =0.75

to construct a portfoilio which has a beta of 1.5 we have to invest 75% of our money in stock X and remaining in riskfree asset

E) expected return = 0.22*.75 +0.25*0.06 = 16.5% + 1.5% = 18%

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