Question

Stock ABC has a beta of 1.4 and the standard deviation of its returns is 30%. The market risk premium is 5% and the risk-free rate is 3%.

1. What is the expected return for the stock?
2. What are the expected return and standard deviation for a portfolio that is equally invested in the stock and the risk-free asset?
3. If you forecast that next year stock ABC will have return of 10%. Would you buy it? Why or why not?

Answer 1

1

As per CAPM

expected return = risk-free rate + beta * (Market risk premium)

Expected return% = 3 + 1.4 * (5)

Expected return% = 10

2

Weight of Stock ABC = 0.5

Weight of risk free asset = 0.5

Return of Portfolio = Weight of Stock ABC*Return of Stock ABC+Weight of risk free asset*Return of risk free asset

Return of Portfolio = 10*0.5+3*0.5

Return of Portfolio = 6.5

Std dev of portfolio = weight of stock *std dev of stock = 0.5*30=15

3

Buy stock as forecasted return =expected return, if investor is happy to earn 10%