Question

Assume that the economy has three types of people. 20% are fad followers, 75% are passive investors and 5% are informed traders. The portfolio consisting of all informed traders has a beta of 1.4 and an expected return of 12.4%. The market has an expected return of 10% and the risk-free rate is 4%. The expected return for the fad follower's portfolio is closest to:__________.
a. 11.5%
b. 13.6%
c. 16%
d. 12.4%

Answer 1

Answer: a. 11.5%

Explanation:

Fad followers are those investors who follow a trend when it emerges and as such their betas will be less than that of informed traders because the informed traders would have acted first.

Using the Capital Asset Pricing Model to calculate expected return.

Er = Rf + b( Rm - Rf)

Er = Expected return

Rf = Risk Free Rate

b = Beta

Rm = Market Return.

The Expected Return for the Informed Investors is,

= 4% + 1.4 ( 10% - 4%)

= 4% + 1.4 ( 6%)

= 12.4%

With the Fad followed expected to have a lower beta and therefore a lower expected return than the Informed Investors, the only suitable option is the 11.5%.