Question

1. Your client decides to invest $1.4 million in Flama stock and $0.6 million in Blanca stock. The risk-free rate is 4% and the market risk premium is 5%. The beta of the Flama Stock is 1.2; and the beta of the Blanca stock is 0.8.
   1. What are the weights for this portfolio?
   2. What is the portfolio beta?
   3. What is the required return of the portfolio?

Answer 1

a.Total value of the portfolio= $1.4 million + $0.6 million

= $2.0 million

Weight of Flama stock= $1.4 million/ $2.0 million*100

= 0.70*100

= 70%.

Weight of Blanca stock= $0.6 million/ $2.0 million*100

= 0.30*100

= 30%.

b.Portfolio beta= 0.70*1.2 + 0.30*0.8

= 0.84 + 0.24

= 1.08

c.The expected return on a stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 4% + 1.08*5%

= 4% + 5.40%

= 9.40%.

In case of any query, kindly comment on the solution.