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Securities: What expected rate of return would a security earn if it had a 0.6 correlation with the market portfolio and a standard deviation of 3 percent?

A portfolio that combines the risk-free asset and the market portfolio has an expected return of 22 percent and a standard deviation of 5 percent. The risk-free rate is 4.9 percent, and the expected return on the market portfolio is 19 percent. Assume the capital-asset-pricing model holds. What expected rate of return would a security earn if it had a 0.6 correlation with the market portfolio and a standard deviation of 3 percent?

Solution Preview

Capital Market Line (CML):

The risk-free rate asset has a return of 5% and a standard deviation of zero and the portfolio has an expected return of 25% and a standard deviation of 4%. These two points must lie on the Capital Market Line.

The slope of the Capital Market Line is:

Slope of CML = Increase in Expected Return / Increase in Standard Deviation
= (0.25- 0.05) / (0.04 - 0)
= 5

According to the ...

Solution Summary

Expected rate of return on securities is investigated in this solution, which discusses the capital market line and demonstrates through step by step calculations how to find the expected return on the security.

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