# Beta, required return, Security market line

1. An individual has $35,000 invested in a stock which has a beta of 0.8 and $40,000 invested in a stock with a beta of 1.4, if these are the only two investments in her portfolio, what is her portfolio's beta?

2. Suppose you are the money manager of a $4 million investment fund. The fund consists of 4 stocks with the following investments and betas;

Stock Investment Beta

A $ 400,000 1.50

B 600,000 (0.50)

C 1,000,000 1.25

D 2,000,000 0.75

If the market required rate of return is 14 percent and the risk-free rate is 6 percent, what is the fund's required rate of return?

3. Given the following set of data;

Historical Rates of Return

Year NYSE Stock X

1 (26.5%) (14.0%)

2 37.2 23.0

3 23.8 17.5

4 (7.2) 2.0

5 6.6 8.1

6 20.5 19.4

7 30.6 18.2

a. Use a spreadsheet or calculator with a linear regression function to determine stock X's beta coefficient.

b. Determine the arithmetic average rates of return for stock X and the NYSE over the period given. Calculate the standard deviations of returns for both stock X and the NYSE.

c. Assuming (1) that the situation during years 1 to 7 is expected to hold true in the future (that is, Rx = Rx; Rm = Rm; and both Ox and bx in the future will equal their past values. (2) That stock X is in equilibrium (that is, it plots on the security market line), what is the risk-free rate?

d. Plot the security market line.

e. Suppose you hold a large, well-diversified portfolio and are considering adding to the portfolio and are considering adding to the portfolio either stock X or another Stock, stock Y, that has the same beta as stock X but a higher standard deviation of returns. Stocks X and Y have the same expected returns; that is

^ ^

RX = RY = 10.6%. Which stock should you choose?

4. Given the following set of data:

Historical Rates of Return

Year NYSE Stock Y

1 4.0% 3.0%

2 14.3 18.2

3 19.0 9.1

4 (14.7) (6.0)

5 (26.5) (15.3)

6 37.2 33.1

7 23.8 6.1

8 (7.2) 3.2

9 6.6 14.8

10 20.5 24.1

11 30.6 18.0

Mean = 9.8% 9.8%

o = 19.6% 13.8%

a. Construct a scatter diagram showing the relationship between returns on stock Y and the market. Use a spreadsheet or a calculator with a linear regression function to estimate beta.

b. Give a verbal interpretation of what the regression line and beta coefficient show about stock Y's volatility and relative riskiness as compared with those of other stocks.

c. Suppose the scatter of points had been more spread out, but the regression line was exactly where your present graph shows it. How would this affect (1) the firm's risk if the stock is held in a one-asset portfolio and (2) the actual risk premium on the stock if the CAPM holds exactly?

d. Suppose the regression line had been downward sloping and the beta coefficient had been negative. What would this imply about (1) stock Y's relative riskiness, (2) its correlation with the market, (3) its probable risk premium?

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#### Solution Summary

Answers questions on Beta, required return, Security market line, linear regression etc.

Draw the Security market line (SML) and risk premium; required returns for assets

Assume that the risk-free rate, is currently 9% and that the market return is currently 13%.

a. Draw the security market line(SML) on a set of "nondiversifiable risk (x-axis) required return (y-axis)" axes.

b. Calculate and label the market risk premium on the axis in part a.

c. Given the previous data, calculate the required return on asset A having a beta of .80 and asset B having a beta of 1.30.

d. Draw in the betas and required returns from part c for assets A and B on the axes in part a. Label the risk premium associated with each of these assets,and discuss them.