The capital asset pricing model (CAPM) explains how risk should be consldered when stocks and other assets are held The CAPM states that any stock's required rate of return is the riak-free rate of rekum plus a risk premium that reflects only the risk remaining diversification, Most individuals hold stocks in portfolios: The risk of a stock beld in a portfolio is typically the stock's risk when it is held alone. Therefore, the risk and return of an individual stock should be analyzed in terms of how the security affects the risk and retum of the portfolio in which it is held. The expected rate of return on a portfolio equas the weighted average of the expected returns on the assets held in the portfalio. A portfolio's risk weighted sverage of the ind widual stocis' standard deviations; the portfolio's risk is generally because diversification the portfolio's nisk. Two important terms when dscussing are correlation and correlation coefficient. Correlation is the tendency of two variables to move together, while correlation coefficient is a measure of the degree of relationship between two variables. If a portfolio consists of two stocks that are perfectly correlated then the portfolio is risidess because the stocks' returns move countercyclically to each other. If the returns of the stocks are perfectly correlated then the stocks' returns would move up and down together and the portfolio would be exactly as risky as the individual stocks. In this situstion, diversification would be completely for reducing risk, in reality, most stocks are correlated but not perfectly, So, combining stocks into portfolios reduces risk but does not completely eliminate it. This iliustrates that can recuce risk, bit not completely eliminote risk. Nartfolio risk can be broken down into two types. and is also known as company-specific risk. On the other hand, standerd deviation is not a good measure of ris when a stock is held in a pents is the risk that remains in a portfolio after diversification has eliminated all company-specific risk. contribution to the portfolio's market risk is measured by a stock's] market. Mn average stock's beto is 1 is considered to here high risk, whiln a stock with beta nisk is that part of a socurity's risk associated with random events. ft can be eliminated by proper diversification risk is the risk that rensins in a portfolio after diversification has eliminated all company-specinc ris is held in a partfolio. A stock's relevant risk is the risk that remains once a stock is in a diversifed portfolio. Its inhich shows the extent to which a given stock's returns move up and down with the stock 1 becavse an overaje-risk stock is one that tends to move up and down in step with the general market. A stock with a beta I is considered to have low rik. Quantitative Problemi You are holding o portfolio with the following investments and betas: The market's required return is 10% and the risk-free rate is 3%. What is the portfolio's required return? Do not round intermediate calculations, Round your answer to three decimal places. 46