Based on current dividend yields and expected capital gains, the expected rates

Question

Based on current dividend yields and expected capital gains, the expected rates of return on portfolios A and B are 10% and 13%, respectively. The beta of A is .8, while that of B is 1.5. The T-bill rate is currently 5%, while the expected rate of return of the S&P 500 index is 11%. The standard deviation of portfolio A is 10% annually, while that of B is 31%, and that of the index is 20%.

a. If you currently hold a market-index portfolio, would you choose to add either of these portfolios to your holdings? Explain.

b. If instead you could invest only in bills and one of these portfolios, which would you choose?

[Hint: This problem is slightly changed from the original problem in book. Search for the original problem (and solution) in the study guide for reference.]

Explanation / Answer

The given data are tabulated as below: Expected Return Beta SD Portfolio A 10 0.8 10% Portfolio B 13 1.5 31% S&P 500 index 11 1.0 20% T-Bill rate 5 0 0% a) The expected returns of a security as per SML = risk free rate + beta*market risk premium. Expected return for Portfolio A = 5 + 0.8*(11-5) = 9.8%                                   for Portfolio B = 5 + 1.5*(11-5) = 14.0% Since Portfolio A's expected return is more than the SML mandated return, it should be chosen. b) The selection is to be based on the reward-variability ratio or the slope of the CAL Slope is given by = (E(Ri) - Rf)/SDi Expected Return SD Slope Portfolio A 10 10% 0.50 Portfolio B 13 31% 0.26 S&P 500 index 11 20% 0.30 Invest in A as its reward - variability ratio is high.

Related Questions

Navigate

• Browse (All)
• Browse B
• Subjects

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