Question

15. Answer the questions below using the following information on stocks A, B, and C.

	A	B	C
Expected Return	13%	13%	10%
Standard Deviation	12%	10%	10%
Beta	1.6	2	0.5

            

            Assume the risk-free rate of return is 4% and the expected market return is 10%

1. Assuming an investor who will invest all of his money into one security, which stock will the investor choose?
2. Assuming an investor with a well-diversified portfolio, which stock would the investor want to add to his portfolio?

Can someone explain why for each answer? Struggling trying to grasp concept

Answer 1

	Expected Return	13%	13%	10%
	Standard Deviation	12%	10%	10%
	Beta	1.6	2	0.5
	Required return as per CAPM = Risk free return +(Market return-risk free rate)*Beta
		i	ii=4%+(10%-4%)*i
	Stock	Beta	Required return		Expected return
	A	1.6	13.600%		13%
	B	2	16.000%		13%
	C	0.5	7.000%		10%
Ans a)	Assuming an investor who will invest all of his money into one security, which stock will the investor choose?
	Alpha of the stock = Required return - Expected return
		i	ii	iii=i-ii
	Stock	Required return	Expected return	Alpha
	A	13.600%	13%	0.600%
	B	16.000%	13%	3.000%
	C	7.000%	10%	-3.000%
	We can see that stock B has positive alpha of 3%. Therefore its undervalued.
	Stock B shold be bought
Ans b)	well-diversified portfolio, which stock would the investor want to add to his portfolio
	Investor will add stock which has low beta.
	In current situation we see that stock C has the lowest beta.
	Therefore investor should choose stock C.