Asked by Alvin Sebastian on Jun 20, 2024
Verified
Stock A has an expected return of 12%,a beta of 1.2,and a standard deviation of 20%.Stock B also has a beta of 1.2,an expected return of 10%,and a standard deviation of 15%.Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B.The correlation between the two stocks' returns is zero (that is,rA,B = 0) .Which of the following statements is correct?
A) The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is overvalued.
B) The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued.
C) Portfolio AB's expected return is 11.0%.
D) Portfolio AB's beta is less than 1.2.
Standard Deviation
A statistical measure that quantifies the amount of variation or dispersion of a set of data values from its mean.
Portfolio AB
A collection of financial investments like stocks, bonds, commodities, cash, and cash equivalents, including mutual funds and ETFs.
Correlation
A statistical measure that describes the extent to which two variables change together, indicating the strength and direction of their relationship.
- Master the elementary aspects of the Capital Asset Pricing Model (CAPM) and how it pertains to estimating returns on stocks.
Verified Answer
Since the correlation between the two stocks' returns is zero, there are no diversification benefits from combining them in a portfolio. The expected return of Portfolio AB is calculated as the weighted average of the individual stock's expected returns:
Expected return of Portfolio AB = (900,000/1,200,000) x 12% + (300,000/1,200,000) x 10% = 11.0%
Therefore, Choice A is correct.
Learning Objectives
- Master the elementary aspects of the Capital Asset Pricing Model (CAPM) and how it pertains to estimating returns on stocks.
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