Suppose that the index model for stocks A and B is estimated from excess returns with the following results: RA = 4.0% + 0.50RM + eA RB = –1.2% + 0.70RM + eB σM = 17%; R-squareA = 0.26; R-squareB = 0.18 Assume you create a portfolio Q, with investment proportions of 0.40 in a risky portfolio P, 0.35 in the market index, and 0.25 in T-bill. Portfolio P is composed of 70% Stock A and 30% Stock B. What is the beta of portfolio Q? (Do not round intermediate calculations. Round your answer to 2 decimal places.) What is the "firm-specific" risk of portfolio Q? (Calculate using numbers in decimal form, not percentages. Do not round intermediate calculations. Round your answer to 4 decimal places.)
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Suppose that the index model for stocks A and B is estimated from excess returns with the following results: RA = 4.0% + 0.50RM + eA RB = –1.2% + 0.70RM + eB σM = 17%; R-squareA = 0.26; R-squareB = 0.18 Assume you create a portfolio Q, with investment proportions of 0.40 in a risky portfolio P, 0.35 in the market index, and 0.25 in T-bill. Portfolio P is composed of 70% Stock A and 30% Stock B.
What is the beta of portfolio Q? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
What is the "firm-specific" risk of portfolio Q? (Calculate using numbers in decimal form, not percentages. Do not round intermediate calculations. Round your answer to 4 decimal places.)
Given:
RA = 4.0% + 0.50RM + eA
RB = –1.2% + 0.70RM + eB
σM = 17%
R-squareA = 0.26
R-squareB = 0.18
From the equation of expected return of Stock A and B
Beta(A) = 0.50
Beta(B) = 0.70
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