How can I set this question up?

Client has 800,000 that must be invested in 3 funds. 20 to 40% invested in growth fund, 20 to 50% in income fund and at least 30% in money market fund. Client has a max risk index of 0.05. Risk indicators - growth fund is 0.10, income fund is 0.07 and money market is 0.01. Portfolio risk index is computed as a weighted average of risk rating for the three funds where the weights are the fraction of the clients portfolio invested in each of the funds.
Yields are growth - 18%, income fund - 12.5% and money market - 7.5%.

Forgot to add - Maximize the Yield

Hi,
I need some help on finance investments homework. Can you help me?

If the risk-free rate is 6 percent and the expected rate of return on the market portfolio is 14 percent, is a security with a beta of 1.25 and an expected rate of return of 16 percent overpriced or underpriced?

Explain Bot Explain Bot answered
9 months ago

To set up this question, you need to understand the concepts of risk-free rate, expected rate of return on the market portfolio, security beta, and expected rate of return.

Here's how you can set up the question:

1. Define the risk-free rate: The risk-free rate is the rate of return on a risk-free investment, such as a government bond. In this case, the risk-free rate is given as 6 percent.

2. Define the expected rate of return on the market portfolio: The expected rate of return on the market portfolio represents the average return of all investments in the market. Here, it is given as 14 percent.

3. Define the security beta: The security beta measures the sensitivity of a security's returns to the overall market returns. A beta higher than 1 indicates that the security is more volatile than the overall market, while a beta less than 1 indicates that the security is less volatile. In this case, the security has a beta of 1.25.

4. Define the expected rate of return on the security: The expected rate of return on the security is given as 16 percent.

Now, to determine if the security is overpriced or underpriced, you need to compare its expected rate of return with the required rate of return based on its risk level.

The required rate of return can be calculated using the capital asset pricing model (CAPM):

Required Rate of Return = Risk-Free Rate + Beta * (Expected Rate of Return on the Market Portfolio - Risk-Free Rate)

Plug in the values:

Required Rate of Return = 6% + 1.25 * (14% - 6%) = 6% + 1.25 * 8% = 16%

The required rate of return is 16%.

If the expected rate of return on the security is equal to the required rate of return, the security is considered fairly priced. If the expected rate of return is higher, the security is considered underpriced, and if it is lower, the security is considered overpriced.

In this case, the expected rate of return on the security is also 16 percent, which is equal to the required rate of return. Therefore, the security is considered fairly priced.

Overall, the security is neither overpriced nor underpriced based on the values given.