Question

Lynn Londergan, investment analyst for the Tempel and Bull Company, typically invests in high beta stocks. Lynn has invested in Xezer, Cable II, International Four, and Gamma, with betas of 2.2, 1.6, 2.4, and 1.8, respectively.

1. Assuming that Lynn has invested in these stocks by equal market values, what exactly is the beta for this portfolio? (2 pts)

2. If the risk-free rate of return is 7% and the required return on the market portfolio is 12%, what is the required rate of return on the portfolio? (2 pts)

3. If you observe stock prices that would lead to an expected return of 15% on this portfolio, would you be willing to buy it? Why or why not? Use a graph in explaining your choice. Label all components of the graph appropriately as well as all points that you are able to compute with the above information. (4 pts)

Answer 1

A) Beta of portfolio is weighted average of individual assets beta, hence it would be

= Sum of (Individual weight * individual beta)

= 0.25*(2.2+1.6+2.4+1.8) = 2

B) Applying CAPM and Beta of 2.

CAPM = Rf+Beta*(Rm-Rf)

= 7%+2*(12%-7%) = 17%

C) If the stock is giving a return of 15%, it would be less than the expected return of 17% from the stock, hence I would not buy it. Its clear from the chart below that at Beta of 1.6, return should be 15%, hence can't accept 15% return for Beta above 1.6.

CAPM Return expected 20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 1 1.6 1.8 2 22 24