We have the following CAPM E(Ri) = .06 + .08 Beta; a) If Stock X has a beta of 2, what is the required rate of return? b) If we form a portfolio that is invested 40% in Stock X and 60% in the risk free asset, the expected rate of return on that portfolio? What is the beta of that portfolio? Stock Z has a beta of 1.5 and an expected return of 15%. Is at a good buy? d)Construct a portfolio of Stock X and the risk free asset which has a beta of 1.5. what is c) e) What is the expected return for this purpose?

Please kindly go through explanation for the answers.

Explanation:

A)The required return if Beta is 2 = 0.06+0.08*2 =0.22

B)Here Rf = 0.06

Expected return of the portfolio = 0.4*22% + 0.6*6% =12.4%

since beta of Rf = 0,the expected beta = 0.4*2 = 0.8

C)Beta is nothing but systematic risk of a security in comparing to the market. In this case stock z having beta of 1.5 which is less than beta of stockX i.e 2. and expected return is 15%.so stockz is offering lower return at lower risk. If the investor is a risk averse its a good buy.

D) let W be portion of stock X.

Then w*2 + (1-w)*0 = 1.5

W = 1.5/2 =0.75

to construct a portfolio which has a beta of 1.5 we have to invest 75% of our money in stock X and remaining in risk free asset

E) expected return = 0.22*.75 +0.25*0.06 = 16.5% + 1.5% = 18%

rational decision making is a multi-step process for making choices between alternatives. the process of rational decision making favors logic, objectivity, and analysis over subjectivity and insight. the word “rational” in this context does not mean sane or clear-headed as it does in the colloquial sense.

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