Consider the following information for stocks A, B, and C. The returns on the th

Question

Consider the following information for stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

What is the market risk premium (rM - rRF)? Round your answer to two decimal places.
%

Explanation / Answer

For Fund P, 1/3 of investment is made in A, 1/3 in B and remaining in C.

Expected Return of a portfolio = Weighted average of the returns of individual components.

Expected Return of Portolio = (1/3) * 9.34% + (1/3) * 10.78% + (1/3) * 13.18% = 11.10%

Similary, Beta of portfolio is weighted average of beta of individual components of portfolio.

Beta of Portolio = (1/3) * 0.8 + (1/3) * 1.1 + (1/3) * 1.6 = 1.17

Based on CAPM Equation, Expected return on portfolio/stock is given by the formula:

Expected return on portfolio/stock = Risk free rate + Beta * (Market Risk Premium)

Substituting values in question,

11.10% = 5.5% + 1.17 * Market Risk Premium

Market Risk Premium = 5.6%/1.17

Market Risk Premium = 4.79%

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