Question

A recent inheritance from your late uncle’s estate has provided you with funds available for investment. You have been provided with the following information for three stocks: Stocks X, Y, and Z.              

Stock	Expected Return	Standard Deviation	Beta
X	8.00%	15%	0.5
Y	9.50%	15%	0.9
Z	13.50%	15%	1.4

The returns on the three stocks are positively correlated, but they are not perfectly correlated. (I.e., each of the correlation coefficients is between 0 and 1.0.) There are two diversified stock funds available into which you could invest your inheritance funds:

Fund P has thirty percent of its funds (30%) invested in Stock X and seventy percent (70%) invested in Stock Y.

Fund Q has one-third (33.33%) of its funds invested in each of the three stocks.

The risk-free rate (R _F ) is 3.5%, and the market is in equilibrium. (I.e., the required returns equal the expected returns.) The market average rate of return ( r _m ) is 8%.

1. What is the portfolio beta for each of the available stock funds?

a. Fund P:

b. Fund Q:

2. What is the generic equation for the Security Market Line (SML) that would apply to all publicly-traded stock shares, using the variables for the risk-free rate ( R _F ) and the market average rate of return ( r _m ) that are provided in the case study above?

3. Using the Security Market Line (SML) equation that you developed in Question #2 above, calculate the required rate of return on each of the available stock funds:

a. Fund P:

b. Fund Q:

4. Based on your calculations, which stock fund appears to be most risky? Why?

5. Into which fund would you invest your inheritance funds? Why?

              

Answer 1