Problem 6-14 Suppose that many stocks are traded in the market and that it is po
ID: 2714709 • Letter: P
Question
Problem 6-14
Suppose that many stocks are traded in the market and that it is possible to borrow at the risk-free rate,rƒ. The characteristics of two of the stocks are as follows:
Calculate the expected rate of return on this risk-free portfolio? (Hint: Can a particular stock portfolio be substituted for the risk-free asset?) (Round your answer to 2 decimal places.)
Could the equilibrium rƒ be greater than 7.00%?
Suppose that many stocks are traded in the market and that it is possible to borrow at the risk-free rate,rƒ. The characteristics of two of the stocks are as follows:
Explanation / Answer
Since the stocks are perfectly negatively co-orelated the portfolio variance is zero.
wA = weighting of asset A
wB = weighting of asset B
sdA = standard deviation of asset A
sdB = standard deviation of asset B
p = correlation of A and B
portfolio variance = wA^2*sdA^2 + wB^2*sdB^2 + 2*wA*wB*p*sdA*sdB
Here p=-1 and implies wAsdA=wBsdB
Let wb be (1-wA)
0.25*wA=0.75* (1-wA) and wA=75% and wB= 25%
E(R)=(0.75*6)+(0.25*10)= 7%
b)No as te stocks are perfectly negatively correlated their return ahs to be same as risk free rate whch is 7%