Risk, Return, and the Capital Asset Pricing Model



Risk, Return, and the Capital Asset Pricing Model

As a first day intern at Tri-Star Management Incorporated the CEO asks you to analyze the following information pertaining to two common stock investments, Incorporated and Sam’s Grocery Corporation. You are told that a one-year Treasury Bill will have a rate of return of 5% over the next year. Also, information from an investment advising service lists the current beta for as 1.68 and for Sam’s Grocery as 0.52. You are provided a series of questions to guide your analysis.

Estimated Rate of Return .

Economy Probability Sam’s Grocery S&P 500

Recession 30% –20% 5% – 4%

Average 20% 15% 6% 11%

Expansion 35% 30% 8% 17%

Boom 15% 50% 10% 27%

Assignment

1. Calculate the expected rate of return for Incorporated, Sam’s Grocery Corporation, and the S&P 500 Index.

2. Calculate the standard deviations in estimated rates of return for Incorporated, Sam’s Grocery Corporation, and the S&P 500 Index.

3. Which is a better measure of risk for the common stock of Incorporated and Sam’s Grocery Corporation—the standard deviation you calculated in Question 2 or the beta?

4. Based on the beta provided, what is the expected rate of return for Incorporated and Sam’s Grocery Corporation for the next year?

5. If you form a two-stock portfolio by investing $30,000 in Incorporated and $70,000 in Sam’s Grocery Corporation, what is the portfolio beta and expected rate of return?

6. If you form a two-stock portfolio by investing $70,000 in Incorporated and $30,000 in Sam’s Grocery Corporation, what is the portfolio beta and expected rate of return?

7. Which of these two-stock portfolios do you prefer? Why?

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