pset3_2014.pdf - Ec1723 Fall 2014 Problem Set 3 This...

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Ec1723, Fall 2014: Problem Set 3 This assignment is due at the beginning of class on Tuesday, September 30. The assignment will not be accepted after 10.15am on Tuesday, September 30. 1. The riskless interest rate is 3%. You hold a portfolio consisting of short-term safe assets and the market portfolio of risky assets, which has a mean return of 8% and a standard deviation of 20%. You are considering an individual stock that you believe to have a correlation of 0.9 with the market portfolio, and a standard deviation of 40%. a) What is the beta of the individual stock with the market? b) If the CAPM holds, what must be the mean return on the stock? What must be its alpha? c) Suppose the stock has a higher alpha than the CAPM implies. Explain how to change its weight in your portfolio in such a way as to increase the mean return on your portfolio without increasing its variance. (Do this in words, or write down a relevant equation if you can.) d) Now suppose the stock has a lower alpha than the CAPM implies. How does your answer to part c) change? e) Some people argue that deviations from the CAPM are caused by the irrational be-

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