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Investing in Market Based Portfolio

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Based on current dividend yields and expected capital gains, the expected rates of return on portfolios A and B are 11% and 14%, respectively. The beta of A is 0.8, while that of B is 1.5. The T-bill rate is currently 6%, whereas the expected rate of return of the S&P 500 index is 12%. The standard deviation of portfolio A is 10% annually, that of B is 31%, and that of the S&P 500 index is 20%.

a. If you currently hold a market-index portfolio, would you choose to add either of these portfolios to your holdings? Explain.

b. If instead you could invest only in T-bills and one of these portfolios, which would you choose? Why?

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Solution Preview

a. Expected Return of Portfolio A = 11%
Expected Return of Portfolio B = 14%
Beta of Portfolio A = 0.8
Beta of Portfolio B = 1.5
Risk free rate = 6%
Return on Market = 12%
Standard deviation of portfolio A=10%
Standard deviation of portfolio B=31%
Standard deviation of market portfolio =20%

Required return on Stock A using CAPM = Risk free rate + ...

Solution Summary

Details of investing in market based portfolio are implied.