Dr. Goodyear has approached you for financial advice. He has identified two shares, one of Future Growth Ltd (Share F) and another the equity share of Growbig Plc (Share G). He avails the following information to you:
Namibian Economy Probability Expected Return Expected Return
Share F Share G
Depressed 0.3 2% 15%
Buoyant 0.5 10% 22%
Bullish 0.2 12% -2%
Additional information:
1. The return on the Government of Namibia treasury bills is 3%.
2. The market return is 12%.
3. The standard deviation of the expected market return is 6%.
4. The covariance of Share F’s returns with the market is 25.2
5. The covariance of Share G’s returns with the market is 39.6
Required:
(a) Calculate the correlation coefficient of Share F and Share G.
(b) Form a portfolio of 40% Share F and 60% Share G. Using relevant calculations advise Dr. Goodyear whether to invest in the portfolio or either Share F or G.
(c) Calculate the required return for shares F and G according to the Capital Asset Pricing Model and discuss whether you would advise the investor to invest in either Share F or Share G.
(d) Briefly explain why the CAPM uses Beta in calculating expected return and not the standard deviation.