Consider the following information for three stocks, Stock X,Y, and Z. The retur

Question

Consider the following information for three stocks, Stock X,Y, and Z. The returns on the three stocks are positivelycorrelated, but they are not perfectly correlated. (That is ,each of the correlation coefficients is between 0 and 1.) Stock               ExpectedReturn               StandardDeviation              Beta X                        9.00%                                    15%                              0.8 Y                        10.75                                      15                                 1.2 Z                        12.50                                       15                                 1.6 Fund P has half of its funds in Stock X and half investe inStock Y. Fund Q has one-third of its funds in each of thethree stocks. The risk-free rateis 5.5 percent, and themarket is in equilibrium. (That is , required equal expectedreturns.) What is the market risk premium (rm -rRF)? Consider the following information for three stocks, Stock X,Y, and Z. The returns on the three stocks are positivelycorrelated, but they are not perfectly correlated. (That is ,each of the correlation coefficients is between 0 and 1.) Stock               ExpectedReturn               StandardDeviation              Beta X                        9.00%                                    15%                              0.8 Y                        10.75                                      15                                 1.2 Z                        12.50                                       15                                 1.6 Fund P has half of its funds in Stock X and half investe inStock Y. Fund Q has one-third of its funds in each of thethree stocks. The risk-free rateis 5.5 percent, and themarket is in equilibrium. (That is , required equal expectedreturns.) What is the market risk premium (rm -rRF)?

Explanation / Answer

Recall that the equation for the security market line (SML)equation is: ri = rRF + (rM +rRF) bi. Also, rRF (the risk freerate) and rM (market risk rate) are true for the marketas a whole, and are the same for all stocks. To solve this problem, take any stock and use the SML equation tosolve for (rM + rRF). For instance, takeStock Z: r = rRF + (rM + rRF) b 12.50 = 5.5 + (rM + rRF) 1.6 (rM + rRF) = 4.3750 You will get the same answer if you used another stock. Forinstance, take Stock Y: r = rRF + (rM + rRF) b 10.75 = 5.5 + (rM + rRF) 1.2 (rM + rRF) = 4.3750

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