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4. Suppose wehave one risky asset Stock I and a risk-free asset. Stock I has anexpected return of 25% and a beta of 2. The risk-free asset’sreturn is 6%.
a. Calculate the expected returns and betas onportfolios with x% invested in Stock I and the rest invested in therisk-free asset, where x% = 0%, 25%, 75%, 100%, 125%, and150%.
b. What reward-to-risk ratio does Stock I offer? How doyou interpret this ratio?
c. Suppose we have a second risky asset,Stock J. Stock J has an expected return of 20% and a beta of 1.7.Calculate the expected returns and betas on portfolios with x%invested in Stock J and the rest invested in the risk-free asset,where x% = 0%, 25%, 75%, 100%, 125%, and 150%.
d. What reward-to-risk ratio does Stock J offer? How doyou interpret this ratio?
e. Plot the portfolio betas against the portfolioexpected returns for Stock I on a graph, and link all the pointstogether with a line. Then plot the portfolio betas against theportfolio expected returns for Stock J on the same graph, and linkall these points together with another line. (This can be doneeasily with the charting function in Microsoft Excel.)
f. Use the graph in part (e) above, togetherwith your answers to parts (b) and (d) above to explain why Stock Jis an inferior investment to StockI.
g. Can a situation in which one stock is inferior toanother stock persist in a well-organized, active market? Why orwhynot?
