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Q: Finance ( Answered 5 out of 5 stars,   0 Comments )
Question  
Subject: Finance
Category: Business and Money > Finance
Asked by: lrdgz-ga
List Price: $10.00
Posted: 18 Sep 2005 12:31 PDT
Expires: 18 Oct 2005 12:31 PDT
Question ID: 569424
Suppose you have invested $50,000 in the following four stocks:
Stock A - $10,000 - invested beta 0.7
Stock B - $15,000 - invested beta 1.2
Stock C - $12,000 - invested beta 1.4
Stock D - $13,000 - invested beta 1.9

The risk-free rate is 5% and the expected return on the market
portfolio is 18%. Based on the Capital Asset Pricing Model, what is
the expected return on the above portfolio?

Clarification of Question by lrdgz-ga on 18 Sep 2005 13:21 PDT
I would appreciate a response within the next couple of hours.  I'll
make it worth your while in a tip!  Thanks in advance for expediting
your response.
Answer  
Subject: Re: Finance
Answered By: omnivorous-ga on 18 Sep 2005 13:55 PDT
Rated:5 out of 5 stars
 
Lrdgz ?

In this case, the portfolio?s expected returns are simply a weighted
average of the returns of each of the stocks.  The assumptions here
may be as important as the answer.

The CAPM predicts:

Rc = rf + c(rM - rf)

Where,  

Rc is the company's expected return on capital 
rf is the risk-free return rate, usually a long-term U.S. Treasury bill rate 
rM is the expected return on the entire market of all investments. 
Most measures use a common broad index, most often the S&P500 over the
past 5 or 10 years
c is the company's Beta, based on its covariance with the market. 


Our Rc numbers for each stock are:

Stock A (20%): 5% + 0.7 * 13% = 14.1%
Stock B (30%): 5% + 1.2 * 13% = 20.6%
Stock C (24%): 5% + 1.4 * 13% = 23.2%
Stock D (26%): 5% + 1.9 * 13% = 29.7%

The weighting of the portfolio should bring you the following returns:

.20 * 14.1% + .30 * 20.6% + .24 * 23.2% + .26 * 29.7% = 22.29%


The important assumption here is that your portfolio and that stocks
A, B, C, D don?t have a high correlation in returns among themselves. 
In other words, you wouldn?t want them all in the same industry, like
Atmel, Intel, Texas Instruments and National Semiconductor.

Best regards,

Omnivorous-GA
lrdgz-ga rated this answer:5 out of 5 stars and gave an additional tip of: $5.00
Thanks so much for clarifying this for me.

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