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%. (i) 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% (ii) 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% (iii) 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) Sketchthe SML to represent the market’s expected return (Please answer this question) (v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please answer this question)
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%.
(i) Using
Return of stock = Risk free rate + beta ( market
Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12%
Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08%
(ii) 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%
(iii) 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) Sketchthe SML to represent the market’s expected return (Please answer this question)
(v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please answer this question)
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