Check My Work (a remaining) CAPM, portfolio risk, and return Consider the follow

Question

Check My Work (a remaining) CAPM, portfolio risk, and return Consider the following information for three stocks, 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.) 8.40 % 10.53 11.38 14% 14 0.8 returns.) a. What is the market risk premium (M-Far) 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. . What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places. d, would you expect the standard deviation of Fund P to be less than 14%, equal to 14% r greater than 14%? 1, less than 14% n, greater than 14% 111, equal to 14%

Explanation / Answer

Using CAPM, r = rf + *(rm – rf)

Market risk premium = (rm – rf) = (r – rf)/

a:

Using stock A: (rm – rf) = (8.40 – 5)/0.8 = 4.25%

Using stock A: (rm – rf) = (10.53 – 5)/1.3 = 4.25%

Using stock A: (rm – rf) = (11.38 – 5)/1.5 = 4.25%

b:

Beta of fund P = (1/3)*0.8 + (1/3)*1.3 + (1/3)*1.5 = 1.2

c:

Required return on fund P = (1/3)*8.40 + (1/3)*10.53 + (1/3)*11.38 = 10.10%

d:

w1 = w2 = w3 = 1/3

1 = 2 = 3 = 14%

When correlation coefficient is 1,

Variance = (1/3)^2*14^2 + (1/3)^2*14^2 + (1/3)^2*14^2 + 2*(1/3)*(1/3)*14^2*1 + 2*(1/3)*(1/3)*14^2*1 + 2*(1/3)*(1/3)*14^2*1

Variance = (14/3 + 14/3 + 14/3)^2 = 14^2

Standard Deviation = 14%

When correlation coefficient is zero,

Variance = (1/3)^2*14^2 + (1/3)^2*14^2 + (1/3)^2*14^2 = 65.33

Standard Deviation = 8.08%

When correlation coefficient lies between 0 and 1, Standard Deviation lies between 8.08% and 14%

Therefore, for give correlation coefficient varies between 0 and 1, Standard Deviation must be less than 14%

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