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 funds 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 Expected Return Standard Deviation Beta

X 9.00% 15% .7

Y 10.50% 15% 1.1

Z 12.50% 15% 1.7

(a) What is the market risk premium?

(b) What is the required return of Fund Q?

Explanation / Answer

Part a)

We can use CAPM equation here

For Stock A

Er = Rf + MRP x beta

0.09 = 0.05 + MRP x 0.7

0.04 = MRP x 0.70

MRP = 5.71%

Part b)

Fund Q invests the money equally in all three stocks. Therefore, required return would be:

Required return = average return of stocks

                                = (0.09 +0.1050 +0.1250)/3

                                = 10.67%

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