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According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market
- According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market portfolio (m) and 60% of Treasury bills (i.e. risk-free asset)? Assume the risk-free rate is 3% and the market risk premium is 7%? (6 marks)
- You are considering investing in the following two stocks. The risk-free rate is 7 percent and the market risk premium is 8 percent.
Stock | Price Today | Expected Price in 1 year | Expected Dividend in 1 year | Beta |
X | $20 | $22 | $2.00 | 1.0 |
Y | $30 | $32 | $1.78 | 0.9 |
- Compute the expected and required return (using CAPM) on each stock. (8 marks)
- Which asset is worth investing? Support your answer with calculations. (2 marks)
- Which pair of stocks used to form a 2-asset portfolio would have the greatest diversification effect for the portfolio? Briefly explain.
| Correlation |
Stocks A & B | -0.66 |
Stocks A & C | -0.42 |
Stocks A & D | 0 |
Stocks A & E | 0.75 |
(4 marks)
(d) Explain the terms systematic risk and unsystematic risk and their importance in determining investment return.
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