Question

CAPM, PORTFOLIO RISK, AND RETURN Consider the following information for stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.) Stock=A, B, C. Expected Return=9.15 ,11.40, 13.65 Standard deviation:14%, 14, 14 Beta: 0.7, 1.2, 1.7 Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 6%, and the market is in equilibrium. (That is, required returns equal expected returns.) What is the market risk premium (rM - rRF)? Round your answer to two decimal places. B. What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places. C. What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

As given in question, market is in equilibrium and required rate of return is equal to expected rate of return.

By CAPM, Required rate of Return = Risk free rate + Beta * Market Risk Premium

Substitute the required or expected rate of return, risk free rate and beta for any of the three stocks,

9.15% = 6% + 0.7 * market Risk Premium

Market Risk Premium = 4.50% --> Answer

Beta of a portfolio is a weighted average of Betas of individual constituents of the portfolio.

Beta = (1/3) * 0.7 + (1/3) * 1.2 + (1/3) * 1.7 = 1.20 --> Answer

Required Rate of Return for Fund P can be calculated by using the CAPM equation and the values that we calculated above.

Expected Return for Fund P = 6% + (1.20 * 4.50%) = 11.4% --> Answer