Suppose the risk-free rate is 5% and the expected rate of return on the market portfolio is 10%. In your view, the expected rate of return of a security is 12.2%. Given that this security has a beta of 1.4, do you consider it to be overpriced, under-priced or fairly priced according to the Capital Asset Pricing Model? Please provide the details of your calculations and discuss your results
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.
a) Suppose the risk-free rate is 5% and the expected
b)Stock 1 has a standard deviation of return of 6%. Stock 2 has a standard deviation of return of 2%. The correlation coefficient between the two stocks is 0.5. If you invest 60% of your funds in stock 1 and 40% in stock 2, what is the standard deviation of your portfolio? Please provide the details of your calculations and discuss your results.
You decide now to combine your portfolio (discussed in question b) with another portfolio with the same standard deviation and invest equally in both portfolios. The correlation between the two portfolios is zero.
d) What is the standard deviation of this new portfolio? Please provide the details of your calculations and discuss your results.
e) Did we achieve diversification by combining uncorrelated portfolios with identical levels of risk? Explain
Trending now
This is a popular solution!
Step by step
Solved in 4 steps
