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?
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