(2) Consider a market consisting of only two stocks labeled 1 and 2. In the mark

Question

(2) Consider a market consisting of only two stocks labeled 1 and 2. In the market, there are 100 shares of stock 1 sold at $1 per share, and 100 shares of stock 2 with $2 per share. Let the expected returns be µ1 = 10% and µ2 = 6% respectively. Also let the risk-free interest rate be r = 5%, and the standard deviation for the market portfolio M be M = 20%. Assume the market satisfies the CAPM theory.

(2a) Find the expected return µM of the market portfolio.

(2b) Find the beta values 1 and 2.

(2c) Find the covariance 1M between stock 1 and M.

(2d) Suppose an investment opportunity in this market offers an expected return µ = 6% with standard deviation = 19%. Would your portfolio be efficient if you invest all the money in this opportunity? Why?

Explanation / Answer

2a) expected return =( value of shares of A * Return of A + value. Of shared of B * Return of B )/ total value. Of shares = 100/300*10 +200/300*6 =2200/300 = 7.33

2b)B1 =( U1 - Rf) /( Rm - Rf) = 10-5/7.33 -5= 2.145

B2 = (6-5)/(7.33-5) = 0.43

2c) beta = Covariance / Variance

Or, 2.145 = Covariance /(0.2)*0.2

Covariance = 2.145 *0.04 = 8.58%

D)

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