Question

In: Finance

You observe that the risk free rate of return is 2.5 percent and the market risk...

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.

Solutions

Expert Solution

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%.

In case of any query, kindly comment on the solution.

jeff jeffy answered 1 year ago

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