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Question 2 (25 marks) Stock G Assume the risk-free rate is 3% and the market return (RM) is 13%. Stock E Expected Return 18% Standard Deviation 12% Beta Current market price $20 8% 1.2 $30 (a) Most equity research concludes that Stock E is less volatile compared to the market". On average, Stock E's volatility is about 0.6 times that of the stock market (i.e., "the market"). Estimate the required rate of return of Stock E using CAPM. (4 marks) (b) It is expected that Stock G will pay a per-share dividend of $6 one year from now, and the dividend will increase by an average of 5% per year in the foreseeable future. According to CAPM, is Stock Govervalued or undervalued? (9 marks) (c) Suppose you plan to purchase 6,000 shares of Stock E and 12,000 shares in Stock G. (i) Compute the portfolio weights of Stock E and Stock G. (3 marks) (ii) Compute the expected portfolio return. (2 marks) (iii) Assume that the covariance between Stock E and Stock G is -0.005 or -50%. Compute the standard deviation of the portfolio. (4 marks) (d) As noted above, the beta value of Stock G is higher than that of Stock E while the opposite holds true for the standard deviation. Given that both statistics are used to measure the level of risk of an asset/portfolio, explain what account for their differences in values between Stock E and Stock G. (3 marks) 3

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