Consider the following two stocks. The risk-free rate is 4% and the average stoc
ID: 2640692 • 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? You should show your work and explain.
Explanation / Answer
a. In a well diversified portfolio , Stock B should be chosen as it is having beta(0.7) less than beta of stock A(1.2)
b.Reqd rate of return on stock A=4%+(8%*1.2)=13.6%
Reqd rate of return on stock B=4%+(8%*0.7)=9.6%
Reqd rate of return on protfolio=0.5(13.6)+0.5(9.6)=11.6%
c. If the expected return on Stock A is 12%, whereas expected return (calculated above) is 13.6% , Hence security is overpriced in the market . Hence stock A is not good for investment