You own a portfolio that has a total value of 113,000 dollars. The portfolio has

Question

You own a portfolio that has a total value of 113,000 dollars. The portfolio has 7,000 shares of stock A, which is priced at 8.3 dollars per share and has an expected return of 11.48 percent. The portfolio also has 10,000 shares of stock B, which has an expected return of 15.11 percent. The risk-free return is 4.27 percent and inflation is expected to be 2.31 percent. What is the risk premium for your portfolio? Answer as a rate in decimal format so that 12.34% would be entered as .1234 and 0.98% would be entered as .0098.

Explanation / Answer

Portfolio Risk Premium = Expected return on the portfolio - Risk free rate

Let us first calculate Expected return on the portfolio:

Expected Return on the Portfolio = Weight of the stockA * Return on stock A + Weight of stock B * Return on stock B

Value of stock A = 7000 shares * $8.3 = $58,100

Value of stock B = Total Value of portfolio - Value of stock A = $113,000 - $58,100 = $54,900

Weight of Stock A = 58100/11300

Weight of Stock B = 54900/113000

Expected Return on Portfolio = 58100/113000 * 0.1148 + 54900/113000 * 0.1511 = 0.059025+0.0073411 = 0.066367 or 6.64%

Risk free rate = 4.27%

Portfolio Risk Premium = Expected return - Risk free return = 0.006367 - 0.0427 = 0.023667 or 2.4% (Answer)

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