Question
Currently the market expected return, E(RM), the market volatility, M, and the risk-free rate, Rf are 10%, 20%, and 2%, respectively. Assume the CAPM holds.
Currently the market expected return, E(RM), the market volatility, M, and the risk-free rate, Rf are 10%, 20%, and 2%, respectively. Assume the CAPM holds. (a) GM's stock return has a volatility (G) of 25%, and a correlation with the market of GM=0.64. What is GM stock's expected return? (b) What is GM stock's idiosyncratic volatility? (c) Starbuck's stock return has the same volatility, i.e., S=25%, but the correlation with the market portfolio SM = 0.56. Compute Starbuck's S and E(RS). What can you learn by comparing results in (b) and (c) (on expected returns, systematic risk, and idiosyncratic risk)? (d) A portfolio p that invest equally in both GM and Starbuck, has a correlation of pM = 0.75 with the market. What is the portfolio volatility? Comment on the diversification effect!
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