Stocks A and B both have an expected return of 10% and a standard deviation of returns of 25%.Stock A has a beta of 0.8 and Stock B has a beta of 1.2.The correlation coefficient,r,between the two stocks is 0.6.Portfolio P is a portfolio with 50% invested in Stock A and 50% invested in B.Which of the following statements is correct?
A)Portfolio P has a standard deviation of 25% and a beta of 1.0.
B)Based on the information we are given, and assuming those are the views of the marginal investor, it is apparent that the two stocks are in equilibrium.
C)Portfolio P has more market risk than Stock A but less market risk than Stock B.
D)Stock A should have a higher expected return than Stock B as viewed by the marginal investor.

Question

Quizplus · Accepted Answer

Portfolio P has a weighted average beta of (0.8+1.2)/2 = 1.0, which is the same as the beta of the market. However, the standard deviation of the portfolio's returns is not equal to the weighted average of the individual stocks' standard deviations because the stocks may not move perfectly in tandem (i.e., they are not perfectly positively correlated). In this case, because the correlation coefficient is less than 1, the standard deviation of the portfolio's returns will be less than the weighted average of the individual stocks' standard deviations. Therefore, Portfolio P has less market risk than Stock B (which has a higher beta) but more market risk than Stock A (which has a lower beta).

Stocks a and B Both Have an Expected Return of 10