6) Answer the question below using the following information on stocks A, B, and
ID: 2766990 • Letter: 6
Question
6) Answer the question below using the following information on stocks A, B, and C.
A
B
C
Expected Return
20%
21%
10%
Standard Deviation
12%
10%
10%
Beta
1.8
2.2
0.8
Assume the risk-free rate of return is 3% and the expected market return is 12%
a. Calculate the required return for stocks A, B, and C.
b. Assuming an investor with a well-diversified portfolio, which stock would the investor want
to add to his portfolio?
c. Assuming an investor who will invest all of his money into one security, which stock will the investor choose?
A
B
C
Expected Return
20%
21%
10%
Standard Deviation
12%
10%
10%
Beta
1.8
2.2
0.8
Explanation / Answer
a. Expected Return from Stock = Risk free rate + Beta ( Expected market return - Risk free rate )
Expected Return from Stock A = 3% + 1.8 *(12% - 3%) = 3% + 16.2 % = 19.20%
Expected Return from Stock B = 3% + 2.2 *(12% - 3%) = 3% + 19.8 % = 22.80%
Expected Return from Stock C = 3% + 0.8 *(12% - 3%) = 3% + 7.2 % = 10.20%
b. Assuming an investor with a well-diversified portfolio, which stock would the investor want
to add to his portfolio? The Answer is: Stock B is added to the portfolio because of Expected Return from Stock B is higher than Stock A and Stock C.
c. The Slope of Stock = ( Expected Return - Risk free rate ) / Standard Deviation of Stock
Therefore, The Slope of Stock A = (20 - 3) / 12 = 1.4167
The Slope of Stock B = (21 - 3) / 10 = 1.8
The Slope of Stock C = (10 - 3) / 10 = 0.7
The Slope of Stock B is higher than the Stock A and Stock C.
Therefore, Investor who will all of his money into one security, then the investor choose Stock B.
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