Consider the following two stocks. The risk-free rate is 4% and the average stoc
ID: 2640689 • Letter: C
Question
Consider the following two stocks. The risk-free rate is 4% and the average stock's risk premium is 8%.
Stock A Stock B
Beta 1.2 0.7
Standard deviation 11% 15%
a) When you hold a well-diversified portfolio, what stock should you choose to reduce the risk? You should explain.
b) If you construct a portfolio that consists of Stock A and Stock B (only two stocks), find the required rate of return on your portfolio.
c) If the expected return on Stock A is 12%, is it good to invest in this stock?
Explanation / Answer
a) according to rule of dominance when risk and return of two securities are diffrent then deciesion should we based on coefficient of vafriance
C.V.=Standerd deviation/avg.return
now we have return CAPM= Rf+beta(risk premium)
A's return=8+1.2*4=12.8% B's return= 8+.7*4= 10.8
CV of A= 11/12.8=.859:1
CV of B= 15/10.8= 1.38:1
We should select stock A
b) assuming both are equal in weight
return of portfolio =A's avg. return*weight+B's avg. return*weight
= 12.8*.5+10.8*.5
=11.8%
c) here CAPM>expected return i.e. overvalued and we should not invest