Question

 

Your financial planner gave you the following information about the two stocks. The risk free rate is 3%.

Google expected return 15% s.d. of return 8% Beta 1.2

GE expected return 9% s.d. of return 5%

8. Which one is a better investment opportunity based on Sharpe Ratio?

9. You want to invest $2,400 on GE and the $5,600 on Google. What is the expected return of your portfolio of two stocks?

10. Given the risk free rate 3%, Google’s Beta and expected return rate above, what must be the expected return rate of the stock market E(rm) according to CAPM formula?

Answer 1

Sharpe ratio = (Mean portfolio return - Risk-free rate)/Standard deviation of portfolio return
Higher the sharpe ratio, higher the relative return on risk being taken by investor
	Google	GE
Expected return	15%	9%
Risk free rate	3%	3%
SD	8%	5%
Sharpe ratio=	(15%-3%)/8%	(9%-3%)/5%
Sharpe ratio=	1.50	1.20
As we can see Sharpe ratio of Google is better and hence, Google is better relative to risk being assumed
	Capital	Weight	Expected return	Weighted return
Google	5,600.00	70%	15%	10.500%
GE	2,400.00	30%	9%	2.700%
Total	8,000.00			13.200%
Expected return=	13.200%
Expected return=	Risk free return + Beta * (Market return - risk free rate)
15%=	3%+1.2 * Risk premium
Risk premium=	(15%-3%)/1.2
(Market return - risk free rate)=	10.00%
Market return=	10%+3%
Market return=	13.00%