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

Portfolio P has a beta of 0.5(0.8)+0.5(1.2) = 1. Total risk of P is measured by standard deviation which is the weighted-average standard deviation of the two stocks.

σp = 0.5(25%) + 0.5(25%) = 25%

Therefore, P has less market risk than B, which has a beta of 1.2, but more market risk than A, which has a beta of 0.8. Statement A cannot be determined from the given information. Statement C is incorrect because both stocks have the same expected return. Statement D is incorrect because the coefficient of variation of portfolio P cannot be determined from the given information. Statement E is incorrect because the beta of portfolio P is 1, not 1.2.

Stocks a and B Both Have an Expected Return of 10