Question 2: Consider the following information for Stocks A, B, and C. 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.) Show the step-by-step calculation and circle your answer.

Assume that Amazon company has one-third of its funds invested in each of the three stocks. The risk-free rate (rRF) is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

a. What is the market risk premium (RPM =rM-rRF)?

(Hint: Chose any stock, substitute the given values into the equation Required return = rRF + b(RPM)), and find RPM. Note that Required return is shown as Expected return in the table above.)

b. What is the beta of Amazon? (Hint: find portfolio beta.)

c. What is the required return of Amazon? (Hint: use the results from a and b questions and plug in to the equation of finding a Required return of the portfolio.)

d. Would you expect the standard deviation of Amazon to be less than 15%, equal to 15%, or greater than 15%? Explain. Give a short answer in 1-2 sentences.

Stock Expected Return Standard Deviation Beta A 9.55% 15% 0.9 B 10.45 1.1 15 15 12.70 1.6