Risk and Return

Explain what CAPM tells us and how to practically use CAPM beta for investment decisions.

Consider the following information about three stocks:

State of Economy	Probability of State of Economy	Expected returns of Stock A	Expected returns of Stock B	Expected returns of Stock C
Boom	35%	24%	36%	55%
Normal	50%	17%	13%	9%
Bust	15%	0%	-28%	-45%

1. If your portfolio is invested, 40 percent each in stock A and stock B and 20 percent in stock C, what is the portfolio expected return and the standard deviation and variance.

2. You own a stock portfolio invested 25 percent in Stock Q, 20 percent in Stock R, 15 percent in Stock S, and 40 percent in Stock T. The betas for these four stocks are .84, 1.17, 1.11, and 1.36, respectively. What is the portfolio beta?

3. A stock has an expected return of 13.5 percent, its beta is 1.17, and the risk-free rate is 5.5 percent. What must the expected return on the market be?