The beta of stock A is 1.5 and the beta of the overall market is 1.0. A portfolio is invested 60% in stock A and 40% in the market. The risk-free return and market return are 6% and 17%, respectively.

What is the fair (required) return on the portfolio according to CAPM?

1.20.3%

2. 15.71%

3.15.71%

4. 25.71%

The correct option is 1. 20.3%

Explanation:

For computing the required return on the portfolio, we have to use the CAPM formula which is shown below:

Required rate of return = Risk free rate of return + Beta * (Market return - risk free return)

For Stock A

Required rate of return = Risk free rate of return + Beta * (Market return - risk free return)

= 6% + 1.5 * (17% - 6%)

= 6% + 1.5 * 11%

= 6% + 16.5%

= 22.5%

For Stock B

Required rate of return = Risk free rate of return + Beta * (Market return - risk free return)

= 6% + 1.0 * (17% - 6%)

= 6% + 1.0 * 11%

= 6% + 11%

= 17%

Now multiply the weightage of stock A with required rate of return for the stock A and the weightage of stock B with required rate of return for the stock B to find out the return for the portfolio

In mathematically,

= (Weightage of stock A * required rate of return for stock A) + (Weightage of stock B * required rate of return for stock B)

= (60% * 22.5%) + (40% * 17%)

= 13.5% + 6.8%

= 20.3%

Hence, the fair (required) return on the portfolio according to CAPM is 20.3%

Therefore, the correct option is 1. 20.3%