Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Rf= 2% and Rm = 12%.   Using CAPM, what are the expected returns for each stock?                                     Return of stock = Risk free rate + beta ( market rate of return - risk free rate of return)  Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12% Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08%     What is the expected return of an equally weighted portfolio of these two stocks?   Weight of stock A = 0.50 Weight of Stock B = 0.50 Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B)  = (2.12 * 0.50) + (2.08*0.50)  = 1.06 + 1.04 = 3%     What is the beta of an equally weighted portfolio of these two stocks? Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B)  = (1.20*0.50) + (0.80*0.50)  = 0.60 + 0.40 = 1 Beta of portfolio = 1     (iv)       Sketch the SML to represent the market’s expected return                       (Please do this one)                 (v)       Place Stock A and B on the SML and state if they are over- valued or Under-valued.  (Please do this one)

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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  • Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. Rf= 2% and Rm = 12%.

 

  • Using CAPM, what are the expected returns for each stock?                                    

Return of stock = Risk free rate + beta ( market rate of return - risk free rate of return) 

Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12%

Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08%

 

 

  • What is the expected return of an equally weighted portfolio of these two stocks?

 

Weight of stock A = 0.50

Weight of Stock B = 0.50

Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B)

 = (2.12 * 0.50) + (2.08*0.50) 

= 1.06 + 1.04 = 3%

 

 

  • What is the beta of an equally weighted portfolio of these two stocks?

Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B) 

= (1.20*0.50) + (0.80*0.50) 

= 0.60 + 0.40 = 1

Beta of portfolio = 1

 

 

(iv)       Sketch the SML to represent the market’s expected return                       (Please do this one)                

(v)       Place Stock A and B on the SML and state if they are over- valued or Under-valued.  (Please do this one)                                                                       

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Practice, Practice, Practice!
Question 1: An investor wants to evaluate the $2.5 million portfolio
described below:
Stock
I
II
III
IV
V
Stock's Beta Stock's Expected Return Portfolio Composition
15%
8%
16.25%
12.50%
9%
1.3
0.7
1.25
1.1
0.9
$750,000
$250,000
$500,000
$500,000
$500,000
$2,500,000
Proportions
0.30
0.10
0.20
0.20
0.20
The market rate of return is 11.5 % and the risk free rate is 5.25%.
A. Compute the expected return of the 5-asset portfolio.
B. Compute the weighted-average beta and the expected return according
to CAPM for this 5-asset portfolio.
C. Based on the above calculations, would you recommend for or against
investing in this portfolio. Briefly explain your answer.
Transcribed Image Text:Practice, Practice, Practice! Question 1: An investor wants to evaluate the $2.5 million portfolio described below: Stock I II III IV V Stock's Beta Stock's Expected Return Portfolio Composition 15% 8% 16.25% 12.50% 9% 1.3 0.7 1.25 1.1 0.9 $750,000 $250,000 $500,000 $500,000 $500,000 $2,500,000 Proportions 0.30 0.10 0.20 0.20 0.20 The market rate of return is 11.5 % and the risk free rate is 5.25%. A. Compute the expected return of the 5-asset portfolio. B. Compute the weighted-average beta and the expected return according to CAPM for this 5-asset portfolio. C. Based on the above calculations, would you recommend for or against investing in this portfolio. Briefly explain your answer.
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