Problems

8-13
CAPM, Portfolio Risk and Return-
Consider the following information for three stocks, Stocks X,Y, and Z. 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)

Stock Expected Return Standard Deviation Beta

X 9.00% 15% 0.8
Y 10.75 15 1.2
Z 12.50 15 1.6

Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and
the market is in equilibrium.
A. What is the market rick premium rm - rrf ?
B. What is the beta of Fund Q?
C. What is the required return of Fund Q?
D. Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater
than 15%? Explain.
A. Using Stock X ( or any stock):
9% = rrf = (rm - rrf) bx
9% = 5.5% + (rm - rrf) 0.8
(rm - rrf)= 4.375%

B. bq = 1/3 (0.8) + 1/3(1.2) +1/3 (1.6)

Bq= 0.2667 + 0.4000 = 0.5333
Bq = 1.2

C. rq = 5.5% + 4.375% (1.2)

rq = 10.75%
D. One would anticipate the portfolio’s standard deviation to be less than 15% since the returns on the 3
stocks includedd are not positively correlated.

8-17 Portfolio Beta

Suppose you are the manager of a mutual fund and hold a $10million
stock portfolio with a beta of 1.30. The required market risk premium 7% and the risk-free rate
is 4%. You expect to invest an additional fund of $5 million in a number of stocks and the final
required return of the aggregated fund is expected to be 16%. What should be the average beta
of the new stocks added to the portfolio.

After additional investments are made, for the entire fund to have an expected return of 16%,
the portfolio must have a beta of 1.7143 as shown below:

16% = 4% + (7%)b
b = 1.7143.

Since the fund’s beta is a weighted average of the betas of all the individual investments, we can
calculate the required beta on the additional investment as follows:
10,000,000(1.3) 5,000,000 X
1.7143 = +
15,000,000 15,000,000
1.7143 = 0.867 + 0.333X
0.8473 = 0.333X
X = 2.544

13-17-19-20