I know how to do parts A and B but I do not understand part

I know how to do parts A and B, but I do not understand part C. Could they still use these rates of return for a single stock even though market beta was used for a portfolio?

Solution

Greetings,

As you already know Ist two parts, so I am answering only 3rd part.

Yes above rates can still be used for investment in a single stock as well even though the market beta was used to calculate their respective returns. Let us understand what does beta mean.

As per capital market theory, market rewards only systematic risk and it does not reward unsystematuc or company specific risk. So beta captures the systematic risk which is risk due to change in economic variables. Reward means that if you bear unsystematic risk which is roughly difference between standard deviation (which captures systematic as well as unsystematic risk) minus beta (which captures only the systematic risk), then market will not provide you the extra return as unsystematic risk is diversifiable or can be avoided.

So either we invest in diversified portfolio or in a single stock, required return will remain the same. It is the risk which vary. In a diversified portfolio, risk gets reduced because historically correlation between two stocks is less than 1 and as a result of this unsystematic risk gets cancelled out.

Crux - Both the diversified portfolio and individual stock provide same return (obviously to the extent of investment made in portfolio as % of total funds), but it is risk which is low in a portfolio so on a risk adjusted basis portfolio provides higher return.