Question

JUS You are given the following correlation matrix for Securities J. K. and the Market: Correlation Security Security K Market Security 1.00 0 .84 0.42 Security 0.84 1.00 0.30 Market 0.42 0.30 1.00 You know that the variance for J, K, and the Market are respectively: 0.0144004.0.0225000, and 0.0005760. Also, IRF = 0.02 and RPM - 0.05. Determine the required rate of return for Security J, based on the Capital Market Line. 33.25% 27.00% 30.50% 24.33% 22.00%

Answer 1

27.00%

Required return under Capital market line:

$r_j = r_{RF}+\frac{\textup{Market risk premium}}{\textup{Standard deviation of market}}*\textup{Standard deviation of j(stock) }$

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

A B Security с Variance 0.0144004 0.0225000 0.0005760 Standard deviation 0.1200017 0.1500000 0.0240000 Market Risk free rate Market Risk Premium 0.02 0.05 Required rate of return of J (CML) 27.00% 11

Cell reference -

Security Nm 7 C Variance 0.0144004 0.0225 0.000576 Standard deviation =SQRT(C2) | =SQRT(C3) =SQRT(C4) Market Risk free rate Market Risk Premium 0.02 0.05 00 Required rate of return of J (CML) =C6+((C7\/D4)*D2 12 13

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.