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?

Question

Quizplus · Accepted Answer

Portfolio P has a beta equal to ((0.5)(0.8)) + ((0.5)(1.2)) = 1.0. Because the correlation coefficient is positive but less than 1, the standard deviation of the returns of Portfolio P would be less than 25%. In fact, it would be equal to 0.5 times 25%, or 12.5%. Choice A is incorrect because the fact that the two stocks have the same expected return and standard deviation does not necessarily mean that they are properly priced, only that they are in equilibrium relative to each other. Choices C, D, and E are also incorrect. Beta measures market risk, i.e., the tendency of a stock's price to move up and down with the overall market. A beta of 1.0 indicates average risk. Therefore, Portfolio P has the same market risk as Stock B.

Stocks a and B Both Have an Expected Return of 10