Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%.Stock A has a beta of 0.8 and Stock B has a beta of 1.2.The correlation coefficient, r, between the two stocks is 0.6.Portfolio P has 50% invested in Stock A and 50% invested in B.Which of the following statements is CORRECT?
A) Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium.
B) Portfolio P has more market risk than Stock A but less market risk than B.
C) Stock A should have a higher expected return than Stock B as viewed by the marginal investor.
D) Portfolio P has a coefficient of variation equal to 2.5.
E) Portfolio P has a standard deviation of 25% and a beta of 1.0.

Question

Quizplus · Accepted Answer

The beta is a measure of market risk, with a beta greater than 1 indicating higher market risk and a beta less than 1 indicating lower market risk than the market. Stock A has a beta of 0.8, which means it has less market risk than Stock B, which has a beta of 1.2. Since Portfolio P has 50% invested in Stock A and 50% invested in B, it will have more market risk than Stock A but less market risk than B. Therefore, choice B is correct. The other choices are incorrect. While we can calculate the expected returns and coefficient of variation for the individual stocks and the portfolio, we cannot determine if the stocks are in equilibrium based on the information given, so choice A is incorrect. We do not have any information to suggest that either Stock A or Stock B should have a higher expected return as viewed by the marginal investor, so choice C is incorrect. The coefficient of variation for Portfolio P is not provided, so choice D is incorrect. Finally, while we can calculate the standard deviation and beta of Portfolio P, the question specifically asks for the statement that is CORRECT, and the correct statement is that Portfolio P has more market risk than Stock A but less market risk than B, which is described in choice B, not the standard deviation and beta of Portfolio P, which are provided in choice E, so choice E is incorrect.

Stocks a and B Both Have an Expected Return of 10