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Consider the following information for three stocks, Stocks X, Y, and Z. 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.)

Stock Expected Return Standard Deviation Beta
X 9.00% 15% 0.8
Y 10.75 15 1.2
Z 12.50 15 1.6

Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

a. What is the market risk premium (rM - rRF)?
b. What is the beta of Fund Q?
c. What is the expected return of Fund Q?
d. Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater than 15%? Explain.

Solution Preview

a. What is the market risk premium (rM - rRF)?

Use the CAPM equation to calculate the market risk premium
Required return = Rf + (Rm-Rf) beta
using stock X
9% = 5.5% + (Rm-Rf) 0.8
(Rm-Rf) = (9%-5.5%)/0.8 = 4.375%

b. What is the beta of Fund ...

Solution Summary

The solution explains the calculation of market risk premium, beta, expected return and standard deviation