Question

1. Suppose you collect the information of two stocks:

	Expected Return	Standard Deviation	Beta
Stock A	13%	15%	1.6
Stock B	9.2%	25%	1.1

                                                                                                                                                                                                       

a. If you have a well-diversified portfolio of 50 stocks and you are considering adding either Stock A or B to that portfolio, which one is a riskier addition and why?
If you are a new investor looking for your first stock investment, which is a riskier investment for you and why?

b. If the CAPM model applies for both stock A and stock B, what must be the risk-free rate and the expected return of the market portfolio (50% A and 50% B)?

c. What is the portfolio beta? Use Rf and E(Rm) in this part to calculate portfolio expected return by CAPM model.

Answer 1

a.

In a well diversified portfolio, risk is defined by beta, so Stock A is more riskier

For new investor, it will be a non diversified portfolio, so standard deviation will be used as risk metric as it defined total risk,

So, Stock B will be more riskier

b.

Using CAPM model,

0.13 = Rf + 1.60(Rm - Rf)

(Rm - Rf) = (0.13 - Rf)/1.60

0.092 = Rf + 1.10/1.60[0.13 - Rf]

Rf = 0.84%

Rm = 8.44%

Risk Free Rate = 0.84%

Market Rate = 8.44%

c.

Portfolio Beta = 0.50(1.60) + 0.50(1.10)

Portfolio Beta = 1.35