Question

Suppose that you manage a mutual fund. You have extensively researched two stocks, Citi and Tesla. Given your research, you anticipate that Citi will return 8% next year and that Tesla will return 7%. Tesla stock has a beta of 0.75 and Citi has a beta of 1.9. The yield on a one-year Treasury bond is 2% and you expect the market premium to be 4%. Currently you hold both Citi and Tesla as part of a broadly diversified portfolio meant to mimic the market portfolio. Please use this information to guide your answers to the next three questions.

Using the CAPM, the required return on Citi stock is?

Using the CAPM, the required return on Tesla stock is?

On which of the two stocks, Citi or Tesla, would you choose to reduce the weightin your portfolio, given your research about Citi and Tesla and your analysis in the prior two questions? Provide a clear explanation for your choice.

Answer 1

Solution :- Required return = Risk free return + Beta of stock * Market premium. (CAPM equation).

Required return of Citi Stock = 2 % + 1.9 * 4 %

= 2 % + 7.60 % (Yield of 2 % on Treasury bond represents to risk free return)

= 9.60 %

Required return of Tesla stock = 2 % + 0.75 * 4 %

= 2 % + 3 %   (Yield of 2 % on Treasury bond represents to risk free return)

= 5 %.

Conclusion :-

Required return of Citi Stock	9.60 %
Required return of Tesla stock	5 %

To decrease weight of common stock in an investment portfolio, Citi stock will be selected based on two reasons which are as follows:-

i). The required return on Citi stock (9.60 %) is higher than that of Tesla stock of just 5 % only.

ii). The beta position on Citi stock (1.9) is higher than that of Tesla stock (0.75).