In addition, the market\'s expected return is 15% and the risk-free rate is 5%.
ID: 2804043 • Letter: I
Question
In addition, the market's expected return is 15% and the risk-free rate is 5%. Assume that the residuals of the two stocks are uncorrelated. Answer the following questions.
(i) According to the CAPM, what is the expected return and systematic variance of an equally- weighted portfolio of the two stocks?
(ii) Suppose the advisor tells you that the price of XYZ implies an expected return of 13% and the price of ABC implies an expected return of 17%. According to the CAPM, what position should you take in each of the two securities? Why?
Asset (i) XYZ ABC 3 2 C) . 10% 30.25% 0.6 1.8 10%Explanation / Answer
(i) As per CAPM approach
Expected Return if Rf+(Rf-Rm)
where Rf is risk free rate,Rm is market expected return
Return of XYZ is 0.05+0.6(0.15-0.05)
=0.05+0.6(0.10)
=0.05+0.06
=0.11=11%
The return of ABC is 0.05+1.8(0.15-0.05)
=0.05+1.8*0.1
=0.05+0.18
=0.23=23%
Systematic risk
Total risk=Systematic risk+Unsystematic Risk
i^2=i^2 * m^2 - ei^2
i^2 * m^2 = i^2 + ei^2
Systematic risk =i^2 + ei^2
XYZ
Systematic Risk=10%+7.75%
=17.75%
ABC
Systematic Risk=30.25%+10%
=40.25%
Expected return
The return on ABC is lower than the given hence new rate to be considered
The return on XYZ is higher than the given and hence lod rate to be considered
XYZ ABC Given 13% 17% Calculated 11% 23%Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.