Question

A portfolio manager is holding the following investments: Stock Amount Invested Beta X $12 million 1.4 Y 25 million 1.0 Z 40 million 0.6 The manager plans to sell his holdings of Stock Y. The money from the sale will be used to purchase another $15 million of Stock X and 10 million of Stock Z. The risk-free rate is 5 percent and the market risk premium is 5.5 percent. How many percentage points higher will the required return on the portfolio be after he completes this transaction?

Answer 1

We will apply CAPM model to calculate expected return of the portfolio. In CAPM model we will use the weighted average beta to calculate the expected return as:

Expected return= Risk free rate+ beta*Risk premium

The above picture shows that the expected return initially was 9.70%. Now calculating the expected return after selling stock Y in a similar way as above

Now the expected return is 9.84%, which is 14 basis points higher than initial expected return.