Question: In today's market, the risk-free rate of interest is 5 percent, & the S&P 500 index is returning 13 percent. The stock of Sludge-R-Us Corporation ("the recycling company") has a beta of 0.50 and the beta of Leech Pharmaceuticals Corporation stock ("gets the poison out fast") is 1.20. Investors expect a 10% rate of return from Sludge-R-Us and a 15 percent rate of return from Leech Pharmaceuticals.
Required:
[A] Write the equation of the security market line (SML) using the data from today's market.
[B] What rate of return should investors require from Sludge-R-Us stock?
[C] Is Sludge-R-Us an aggressive or defensive investment? How do you conclude this? What does this mean?
[D] If the stock market fell by 20%, what would happen (on average) to Leech Pharmaceuticals stock?
[E] Consider a portfolio of $30,000 Sludge-R-Us and $10,000 Leech Pharmaceuticals.
(a) Calculate the expected rate of return of this portfolio?
(b) Calculate the beta of this portfolio?