Reference no: EM133074335

Your uncle, Larson E. Whipsnade, has asked you for some financial advice. His retirement savings are currently invested as follows: $20,000 in the riskless asset, $40,000 in GM stock and $40,000 in Microsoft stock. He wants to know if this is a sensible portfolio. You decide to analyze it based on the CAPM model.

You look in a Beta Book and find that GM stock has a Beta of 1.1 and the R2 of the regression is 0.40. Microsoft stock has a Beta of 0.8 and the R2 of the regression is 0.30. Suppose further that the correlation between the return to GM stock and the return to Microsoft stock is 0.3.

(a) If rf is 4% and the expected excess return on the market [E(rM)- rf ] is 6%, what is the expected return on his portfolio?

(b) If the market return has a standard deviation of 20%, compute the variance and standard deviation of his current portfolio. (Hint use the information in the R2 values to calculate the standard deviation of each stock return. Then use the information about the correlations between the two stock returns to calculate the portfolio standard deviation.)

(c) Assuming that the CAPM is correct, find an efficient portfolio that has the same return standard deviation as your Uncle's current portfolio. What is the expected return on this portfolio? How does it compare to the expected return of his current portfolio?