The Treasury bill rate is 3% and the market risk premium is 9%. The standard deviation of the return on the market portfolio is 21%.
a. (15 points) Stock A has an expected return of 6% and a volatility of 35%. Assume that the stock is correctly priced according to the CAPM.
i.(5 points) What is the beta of stock A?
ii.(5 points) What is the covariance between the return on stock A and the return on
the market portfolio?
iii.(5 points) What portfolio P, combining the market portfolio and the risk-free asset,
has exactly the same beta as Stock A? (You have to find the weight on the market
portfolio, 𝑤, and the weight on the risk-free asset, 𝑤, such that your portfolio beta, 𝛽, is equal to the beta of Stock A.)
b. (10 points) Stock B has a beta of 1.65. You have done your own research and you expect the return on Stock B to be 15%.
i.(5 points) What is the alpha of Stock B?
ii.(5 points) Is Stock B correctly priced, underpriced or overpriced? Does stock B lie
above, on or below the Security Market Line (SML)? (Briefly motivate your answer. 3 sentences at most)