Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.5 and...

Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.5 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?

Answers:	a. The portfolio's required return is less than 11%.
	b. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 3%.
	c. If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by 2%.
	d. The required return on the market is 10%.
	e. If the stock market is efficient, Gretta's portfolio's expected return should equal the expected return on the market, which is 11%.

Solutions

Expert Solution

Investment in Stock 1 = $700,000
Investment in Stock 2 = $300,000

Weight of Stock 1 = $700,000 / ($700,000 + $300,000)
Weight of Stock 1 = 0.70

Weight of Stock 2 = $300,000 / ($700,000 + $300,000)
Weight of Stock 2 = 0.30

Portfolio Beta = Weight of Stock 1 * Beta of Stock 1 + Weight of Stock 2 * Beta of Stock 2
Portfolio Beta = 0.70 * 1.50 + 0.30 * 0.80
Portfolio Beta = 1.29

Required Return of Portfolio = Risk-free Rate + Beta * Market Risk Premium
Required Return of Portfolio = 6.00% + 1.29 * 5.00%
Required Return of Portfolio = 12.45%

Therefore, Option A and Option E are incorrect.

Market Risk Premium = Required Return on Market - Risk-free Rate
5.00% = Required Return on Market - 6.00%
Required Return on Market = 11.00%

Therefore, Option D is incorrect.

If Market Risk Premium increases by 2% and Risk-free Rate remain unchanged:

Increase in Required Return of Portfolio = Increase in Market Risk Premium * Beta
Increase in Required Return of Portfolio = 2.00% * 1.29
Increase in Required Return of Portfolio = 2.58%

Therefore, Option B is incorrect.

If Market Risk Premium remain unchanged and Risk-free Rate increases by 2%:

Increase in Required Return of Portfolio = Increase in Risk-free Rate
Increase in Required Return of Portfolio = 2%

Therefore, Option C is correct.

jeff jeffy answered 1 year ago

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