Answer:
a. The required return on Portfolio P would increase by 1%
Explanation:
Assume that in the given question, the Market risk premium is 7% while the risk free return is 5%, then according to the Capital asset pricing model(CAPM), the expected return of stock A and B will be calculated as follows:
CAPM=Risk free return+Beta(Market risk premium)
Expected Return on stock A=5%+0.70*7%=9.9%
Expected Return on stock B=5%+1.30*7%=14.1%
Since the equal amount of 50% of portfolio P has been invested in the stock A and B, therefore, the return on the portfolio P shall be calculated as follows
Expected return on portfolio P=0.50*9.9%+0.50*14.1%=12%
If the market risk premium is increased by 1% i.e. from 7% to 8%, then the expected return of the Stock A and B shall be calculated as follows:
Expected Return on stock A=5%+0.70*8%=10.6%
Expected Return on stock B=5%+1.30*8%=15.4%
Expected return on portfolio P=0.50*10.6%+0.50*15.4%=13%
So the expected return on portfolio P has been increased by 1% i.e. from 12% to 13% when the market risk premium has been increased by 1%.
Based on the above calculations, the answer shall be a. The required return on Portfolio P would increase by 1%
