Question 4

Asset W has an expected return of 8.8 percent and a beta of .85. If the risk-free rate is 2.6 percent, complete the following table for portfolios of Asset W and a risk-free asset. (Leave no cells
blank - be certain to enter "0" wherever required. Do not round intermediate calculations. Enter your expected return answers as a percent rounded to 2 decimal places, e.g., 32.16,
and beta answers to 3 decimal places, e.g., 32.161.)

Percentage of Portfolio in Asset

Porfolio Expected Return Portfolio Beta
W
0 100% 2.6 % 0
25 75 4.15 21.25 0.213
50 50 5.7 42.5 0.425
75 25 7.25 63.75 0.638
100 0 8.8 85 0.850
125 -25 10.35 106.25 1.063
150 -50 11.9 127.5 1.275

Expected return = 0.088

Beta = 0.85
Risk-free return = 0.025

If you plot the relationship between portfolio expected return and portfolio beta, what is the slope of the line that results? (Do not round intermediate calculations and enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)

Slope of SML = (8.80-2.60)/0.85

Slope of SML = 7.29%

Slope of the line 7.29 %

Explanation

Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.

First, we need to find the beta of the portfolio. The beta of the risk-free asset is zero, and the weight of the risk-free asset is one minus the weight of the stock, so the beta of the portfolio is:

βP = XW(.85) + (1 – XW)(0) = .85XW

So, to find the beta of the portfolio for any weight of the stock, we multiply the weight of the stock times its beta.

Even though we are solving for the beta and expected return of a portfolio of one stock and the risk-free asset for different portfolio weights, we are really solving for the SML. Any combination of this stock, and the risk-free asset will fall on the SML. For that matter, a portfolio of any stock and the risk-free asset, or any portfolio of stocks, will fall on the SML. We know the slope of the SML line is the market risk premium, so using the CAPM and the information concerning this stock, the

E(RW) = .088 = .026 + MRP(.85)

MRP = .062/.85
MRP = .0729, or 7.29%

So, now we know the CAPM equation for any stock is:

E(RP) = .026 + .0729βP

The slope of the SML is equal to the market risk premium, which is .0729. Using these equations to fill in the table, we get the following results:

XW E(RP) ßP
0% 2.60% 0
25 4.15 0.213
50 5.7 0.425
75 7.25 0.638
100 8.8 0.85
125 10.35 1.063
150 11.9 1.275