Stock A has expected return of 15% and standard deviation (s.d.) 20%. Stock B has expected return 20% and s.d. 15%. The two stocks have a correlation coefficient of 0.5. 1.Note that Stock A has greater risk (s.d.) that Stock B, but a lower expected return. Explain how is this possible in a world where returns on assets are as predicted by the CAPM. 2. Determine the expected return and the s.d. of portfolio P1, composed by investing 30% in stock A and 70% in stock B. 3. Consider stock C that has expected return 15% and s.d. 15%. Stock C is uncorrelated with either stock A and stock B. Determine the expected return and s.d. of portfolio P2 made by investing 50% in stock C and 50% in portfolio P1.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Stock A has expected return of 15% and standard deviation (s.d.) 20%. Stock B has expected return 20% and s.d. 15%. The two stocks have a correlation coefficient of 0.5.
1.Note that Stock A has greater risk (s.d.) that Stock B, but a lower expected return. Explain how is this possible in a world where
2. Determine the expected return and the s.d. of portfolio P1, composed by investing 30% in stock A and 70% in stock B.
3. Consider stock C that has expected return 15% and s.d. 15%. Stock C is uncorrelated with either stock A and stock B. Determine the expected return and s.d. of portfolio P2 made by investing 50% in stock C and 50% in portfolio P1.
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The standard deviation of portfolio P2, made by investing 50% in stock C and 50% in portfolio P1, is:
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