Part A)
1) Following the CAPM Model:
0.13= 0 06+ Beta (0.13-0.06)
0.13= 0.06+ 0.07 (Beta)
Beta= (0.13-0.06) /0.07
= 1
2) Beta is the measure of a stock volatility or risk embedded in the stock in response to market as a whole. It is considerable that volatility is the amount of uncertainty in the stock price, and it is the beta measure that captures the volatility in response to changes in the market index. Important to note, if the stock has a beta of 1, this indicates that the stock value will mimic the movement in the market index. Similarly, if the stock has a beta greater than 1, stock price will experience higher volatility than the market index, vice-versa.
3) Since stock carries beta of 1, it will have similar required rate of return as the market, i.e. 13%
4) The risk involved in the Olter stock is the same as the risk involved in the market on average basis, therefore the rate of return is same for both.
5) If the beta of the stock has increased to 1.6, this indicates that the stock will experience higher volatility than the market index. In other words, a 1% change in the market index will be followed by an additional 60% change in the stock value. Henceforth, with increase in beta multiple here, the stock return will also increase.
Part B:
a)
b) Holding Period Return: Change in price/ Closing Price
Ralph Lauren= 1.03/106.97= 0.96%
Walmart= 0.81/62.69= 1.29%
General Motors= - 0.27/29.28= -0.92%
McDonalds= 0.56/118.4= 0.47%
iii) Portfolio Return: WeightRalph Lauren* ReturnRalph Lauren +. WeightMcDonalds* ReturnMcDonalds
= 0.25* 0.0096+ 0.25* 0.0129+0.25* -0.0092+ 0.25* 0.0047
= .0024+ 0.0032- 0.0023 + 0.0012
= 0.0045
= 0.45%
iv) Portfolio Beta: WeightRalph Lauren* BetaRalph Lauren +. WeightMcDonalds* BetaMcDonalds
= 0.25* 0.69 + 0.25* 0.38+0.25* 1.46 + 0.25* 0.74
=0.172+0.095+0.365+0.185
= 0.82
v) Referring to the above calculations, we can see as how by diversifying the portfolio with non-correlated stocks, we were able to average out the beta(risk) and thus limiting the exposure of portfolio to extreme risk. In other words, by diversifying the stocks by including the non-correlated stocks, we were able to reduce the risk exposure of our portfolio.
References
Khatri, D. K. (2010). Portfolio Management. In D. K. Khatri, Security Analysis and Portfolio Management (p. 364). Macmillian.
Robinson, T. (2011). Portfolio Risk and Return. In C. Institute, Portfolio Management (pp. 170-172). Boston: Custom.
