Assume that the CAPM holds and that the expected return and standard deviation of the...
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Assume that the CAPM holds and that the expected return and standard deviation of the market portfolio are E[RM] = 0.08 and M = 0.15, respectively. The correlation between the return on the market portfolio and the return on stock A is AM = 0.1. The expected return on stock A is E[RA] = 0.03 and the standard deviation of the return on stock A is A = 0.2. (a) What is the CAPM beta of stock A? (b) What is the risk-free rate? What is the risk-free rate?
There is another stock B that is perfectly negatively correlated with stock A, i.e., AB = 1. The standard deviation of stock B is B = 0.5. What is the covariance of stock B with the market portfolio? What should the expected return on stock B be for it to be correctly priced by the CAPM? Suppose the expected return on stock B is E[RB] = 0.12, describe a strategy that would give you an arbitrage profit. In this strategy, you can trade stocks A and B as well as the risk-free asset at the risk-free rate that you computed in part (b).
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