## Info

The portfolio's expected return is:

This is the same as we had before. The portfolio's variance is:

.20 X (-.0625 - .265)2 + .50 X (.225 - .265)2 + .30 X (.55 - .265)2 0.0466

apP:

So the standard deviation is ^.0466 = 21.59%.

13.3 If we compute the reward-to-risk ratios, we get (22% - 7%)/1.8 = 8.33% for Cooley versus 8.4% for Moyer. Relative to that of Cooley, Moyer's expected return is too high, so its price is too low.

If they are correctly priced, then they must offer the same reward-to-risk ratio. The risk-free rate would have to be such that:

(22% - Rf)/1.8 = (20.44% - Rf)/1.6 With a little algebra, we find that the risk-free rate must be 8 percent:

13.4 Because the expected return on the market is 16 percent, the market risk premium is 16% - 8% = 8%. The first stock has a beta of .7, so its expected return is 8% + .7 X 8% = 13.6%.

For the second stock, notice that the risk premium is 24% - 8% = 16%. Because this is twice as large as the market risk premium, the beta must be exactly equal to 2. We can verify this using the CAPM:

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line