Stocks A and B have the following historical returns: Year Stock A’s Returns, rA Stock B’s Returns, rB2013 (24.25%) 5.50%2014 18.50 26.732015 38.67 48.252016 14.33 (4.50)2017 39.13 43.86 a. Calculate the average rate of return for each stock during the period 2013 through2017. Assume that someone held a portfolio consisting of 50% of Stock A and 50% ofStock B. What would the realized rate of return on the portfolio have been in each yearfrom 2013 through 2017? What would the average return on the portfolio have beenduring that period?b. Calculate the standard deviation of returns for each stock and for the portfolio. c. Assume the risk-free rate during this time was 3.5%. What are the Sharpe ratios forStocks A and B and the portfolio over this time period using their average returns?d. Looking at the annual returns on the two stocks, would you guess that the correlationcoefficient between the two stocks is closer to +0.8 or to -0.8?e. If more randomly selected stocks had been included in the portfolio, which of the followingis the most accurate statement of what would have happened to sp?1. sp would have remained constant.2. sp would have been in the vicinity of 20%.3. sp would have declined to zero if enough stocks had been included.
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.
Stocks A and B have the following historical returns:
Year Stock A’s Returns, rA Stock B’s Returns, rB
2013 (24.25%) 5.50%
2014 18.50 26.73
2015 38.67 48.25
2016 14.33 (4.50)
2017 39.13 43.86
a. Calculate the average
2017. Assume that someone held a portfolio consisting of 50% of Stock A and 50% of
Stock B. What would the realized rate of return on the portfolio have been in each year
from 2013 through 2017? What would the average return on the portfolio have been
during that period?
b. Calculate the standard deviation of returns for each stock and for the portfolio.
c. Assume the risk-free rate during this time was 3.5%. What are the Sharpe ratios for
Stocks A and B and the portfolio over this time period using their average returns?
d. Looking at the annual returns on the two stocks, would you guess that the correlation
coefficient between the two stocks is closer to +0.8 or to -0.8?
e. If more randomly selected stocks had been included in the portfolio, which of the following
is the most accurate statement of what would have happened to sp?
1. sp would have remained constant.
2. sp would have been in the vicinity of 20%.
3. sp would have declined to zero if enough stocks had been included.
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