1. The standard deviation of the market-index portfolio is 25%. A stock has a beta of 1.4 and a residual standard deviation of 30%.
A. Which would cause a larger increase in the stock's variance: an increase of 0.1 in its beta or an increase of 3% (from 30% to 33%) in its residual standard deviation?
B. An investor holds a portfolio consisting of 90% invested in the market-index portfolio and 10% in the stock described above. Which of the changes in part (A) will have a greater impact on the portfolio standard deviation.
3. You are looking at a stock priced at $5 per share that has a forecast return of 12%, a standard deviation of returns of 10%, and a beta of 1.2. The T-Bill rate is 4% and the market risk premium is 5%.
A. What is the expected return according to the capital asset pricing model?
B. Is the stock underpriced, overpriced or priced correctly, and why?