We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It prospers in recessions when other firms are struggling. Consequently, its beta is negative, -0.3.
a. If the interest rate on Treasury bills is 4% and the expected return on the market portfolio is 14%, what is the expected return on the shares of the law firm according to the CAPM?
b. Suppose you invested 70% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio?
The beta of a portfolio is calculated as the average of the betas of the assets in the portfolio, weighted by the market value of each asset. The beta of a portfolio determines the market risk of the portfolio, and consequently its required rate of return.
Answer and Explanation:
a) According to CAPM, the expected rate of return is calculated as follows:
- expected return = risk free rate + beta * market risk premium
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fromChapter 12 / Lesson 3
In this lesson, we'll discuss how investors must understand the systematic risk principle in their portfolio. We'll also explain how investors can measure and define the risk of their portfolios using betas.