Consider the following information for stocks A, B, and C. The returns on the th
ID: 2785234 • Letter: C
Question
Consider the following information for stocks A, B, and C. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)
Fund P has one-third of its funds invested in each of the three stocks. The risk-free rate is 6%, and the market is in equilibrium. (That is, required returns equal expected returns.)
What is the market risk premium (rM - rRF)? Round your answer to two decimal places.
%
What is the beta of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.
What is the required return of Fund P? Do not round intermediate calculations. Round your answer to two decimal places.
%
Would you expect the standard deviation of Fund P to be less than 14%, equal to 14%, or greater than 14%?
Less than 14%
Greater than 14%
Equal to 14%
Stock Expected Return Standard Deviation Beta A 9.44% 14% 0.8 B 11.59 14 1.3 C 12.88 14 1.6Explanation / Answer
Answer a) We will calculate the market risk premium by :-
Expected return of investment = Risk free rate + Beta * (Market risk premium)
9.44% = 6% + 0.8 * (Market risk premium )
(9.44%-6%) / 0.8 = Market risk premium
Market risk premium = 4.3%
I have used Stock A data for calculating the Market risk premium, the value of market risk premium will remain same no matter which ever stock data you choose from the given table.
Answer b)
Fund P Beta = Weight of stock A in Fund P * Beta of A + Weight of stock B in Fund P * Beta of B + Weight of stock C in Fund P * Beta of C
Fund P = 0.3333*0.8 +0.3333*1.3+0.3333*1.6 = 1.23333
Answer c) Required return of Fund P = Weight of stock A in Fund P * Expected return of A + Weight of stock B in Fund P * Expected return of B + Weight of stock C in Fund P * Expected return of C
Required return = (9.44%*0.3333)+11.59%*0.3333+12.88%*0.33333 = 11.303%
Answer d) Since the Covariance of the following stock lies between 0 and 1 the standard deviation of Fund P will be less than 14%, since a correlation coefficient of 1 suggests that the stocks are perfectly correlated and have standard deviation 14%. Hence, The Standard deviation of Fund P is less than 14%.
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