Question

An investor is forming a portfolio by investing $50,000 in stock A that has a beta of 1.50, and $25,000 in stock B that has a beta of 0.90. The market risk premium is equal to 6% and Treasury bonds have a yield of 4%. What is the required rate of return on the investor's portfolio?

a. 11.8%

b. 7.5%

c. 6.6%

d. 6.8%

e. 7.0%

Continued from previous question. Assume the predicted rate of return (expected rate of return) for Portfolio AB is 10%. Compare the required rate of return with the predicted rate of return of Portfolio AB, which of the following statements is most correct?

a. The portfolio should be sold.

b. The portfolio has a smaller expected return than average stocks.

c. The portfolio is not paying dividends.

d. The portfolio is experiencing supernormal growth.

e. The portfolio is a good buy.

Answer 1

a) 11.8%

explanation: return of stock A = risk free rate + beta ( market risk premium)

= 4% + 1.5 (6%)

= 13%

Return from stock B= 4% + 0.9(6%) = 9.4%

Expected return from portfolio = weight × return

= 50,000/ 75,000 × 13% + 25,000/75,000 × 9.4%

= 0.67 × 13% + 0.33 × 9.4%

= 8.71 × 3.1%

= 11.8%

a) The portfolio should be sold

explanation: If the required rate of return (11.8%) is more than predicted return (10%), then the portfolio is overvalued and it should be sold.