An investor can design a risky portfolio based on two stocks, A and B. Stock A h

Question

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 19% and a standard deviation of return of 32%. Stock B has an expected return of 14% and a standard deviation of return of 17%. The correlation coefficient between the returns of A and B is .5. The risk-free rate of return is 7%. The proportion of the optimal risky portfolio that should be invested in stock B is approximately _________.

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 19% and a standard deviation of return of 32%. Stock B has an expected return of 14% and a standard deviation of return of 17%. The correlation coefficient between the returns of A and B is .5. The risk-free rate of return is 7%. The proportion of the optimal risky portfolio that should be invested in stock B is approximately _________.

Explanation / Answer

We know that: R1 = 19%, R2 = 16%, ?1 = 1.5, and ?1 = 1. To tell which investor was a better

predictor of individual stocks, we should look at their abnormal return, which is the ex-post

alpha, that is, the abnormal return is the difference between the actual return and that

predicted by the SML. Without information about the parameters of this equation (risk-free

rate and the market rate of return) we cannot tell which investor is more accurate.

If Rf = 6% and Rm = 14%, then (using the notation of alpha for the abnormal return):

?1 = 19% - [6% + 1.5(14% - 6%)] = 19% - 18% = 1%

?2 = 16% - [6% + 1(14% - 6%)] = 16% - 14% = 2%.

Here, the second investor has the larger abnormal return, and thus he appears to be a more

accurate predictor. By making better predictions, the second investor appears to have tilted his

portfolio toward underpriced stocks.

If Rf = 3% and Rm = 15%, then

?1 = 19% - [3% + 1.5(15% - 3%)] = 19% - 21% = -2%

?2 = 16% - [3% + 1(15% - 3%)] = 16% - 15% = 1%.

answr:b.29%

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.