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Gretta's portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a stock that has a beta of 0.8. The risk-free rate is 6% and the market risk premium is 5%. Which of the following statements is CORRECT?

a. The required return on the market is 10%.
b. The portfolio's required return is less than 11%.
c. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%.
d. If the market risk premium remains unchanged but expected inflation increases by 2%, Gretta's portfolio's required return will increase by more than 2%.
e. If the stock market is efficient, Gretta's portfolio's expected return should equal.

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Answer: c. If the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%.

Explanation:

To prove the above option, the Capital Asset Pricing Model can be used.

Required Return = Risk free rate + portfolio beta(market premium)

Portfolio Beta

This the weighted average of the individual betas.

Total portfolio value = 700,000 + 300,000 = $1,000,000

= ( 1.2 * 700,000/1,000,000) + ( 0.8 * 300,000/1,000,000)

= 0.84 + 0.24

= 1.08

Required return = 6% + 1.08 ( 5%)

= 6% + 5.4%

= 11.4%

Assuming risk-free rate remains unchanged but the market risk premium increases by 2%.

Required return = 6% + 1.08 ( 5% + 2%)

= 6% + 7.56%

= 13.56%

The change in required return

= (13.56% - 11.4%)/11.4%

= 18.9%

Proving that if the risk-free rate remains unchanged but the market risk premium increases by 2%, Gretta's portfolio's required return will increase by more than 2%.

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