Question

You observe that the risk free rate of return is 2.5 percent and the market risk premium is 9 percent. You have $5,000 invested in stock A and $15,000 invested in stock B. You have calculated that the beta of stock A is 1.25 and the beta of stock B is 1.50. Calculate the expected return for your portfolio.

Answer 1

The question is solved by calculating the expected return of each of the stocks.

Stock A

The expected return on a stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 2.5% + 1.25*9%

= 2.5% + 11.25%

= 13.75%

Stock B

The expected return on a stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke=Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 2.5% + 1.50*9%

= 2.5% + 13.50%

= 16%

Total value of portfolio= $5,000 + $15,000

= $20,000

Weight of stock A= $5,000/ $20,000

= 0.25*100

= 25%

Weight of stock B= $15,000/ $20,000

= 0.75*100

= 75%

Expected return of the portfolio= 0.25*13.75% + 0.75*16%

= 3.4375% + 12%

= 15.4375% 15.44%.

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