Consider the following information for Stocks X, Y, and Z. The returns on the th

Question

Consider the following information for Stocks X, Y, and Z. The returns on the three stocks are positively correlated, but they are not perfectly correlated. Fund Q has one-third of its fund invested in each of the three stocks. The risk-free rate is 5% and the market is in equilibrium. (That is, required returns equal expected returns.)

Stock X / Expected return 9.00% / Standard Deviation 15% / Beta 0.7

Stock Y / Expected return 10.50% / Standard Deviation 15% / Beta 1.1

Stock Z / Expected return 12.50% / Standard Deviation 15% / Beta 1.7

What is the market risk premium?

What is the required return of Fund Q ?

Explanation / Answer

Using CAPM to stock X

Returns on stock= Risk free rate+ beta * risk premium

9.00%= 5%+0.7*risk premium

risk premium to stock x= 5.71%

Using CAPM to stock Y

Returns on stock= Risk free rate+ beta * risk premium

10.50%= 5%+1.1*risk premium

risk premium to stock x= 5.00%

Using CAPM to stock Z

Returns on stock= Risk free rate+ beta * risk premium

12.50%= 5%+1.7*risk premium

risk premium to stock x= 4.41%

Now we have to find required rate of return on Q

Reuired rate of return= sum of weight of stock xi* return on stock xi

=(1/3)*9%+(1/3)*10.5%+(1/3)*12.5%

Reuired rate of return on fund Q=10.67%

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