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lecture07ps

# lecture07ps - Sauder School of Business Finance Division...

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Sauder School of Business COMM 374 Jan-Apr 2010 Finance Division Jan Bena Problem Set 7 - Solution Notes 1. (a) According to the CAPM, investors expect a return of E ( R ) = 5% + 1 . 4 × 6% = 13 . 4% . (b) The expected return on the security is given by E ( R ) = E ( D 1 ) + ( E ( P 1 ) - P 0 ) P 0 , where P 0 is today’s price, E ( P 1 ) is next year’s expected price, and E ( D 1 ) is next year’s expected dividend. We know that E ( R ) = 13 . 4%, E ( D 1 ) = \$0, P 0 = \$35. We get E ( P 1 ) = \$39 . 69. (c) Now we have E ( D 1 ) = \$2. We get E ( P 1 ) = \$37 . 69. 2. (a) The statement is FALSE. Suppose that stocks A and B are independent. Then a 50/50 portfolio of A and B has expected return 0 . 5 × 10% + 0 . 5 × 12% = 11% and standard deviation p 0 . 5 2 × (15%) 2 + 0 . 5 2 × (13%) 2 = 9 . 92% . An investor may be willing to hold the 50/50 portfolio, since it has lower standard deviation than both A and B. (b) The statement is FALSE. The equally weighted portfolio is generally not on the portfolio frontier. In the international diversification example presented in the lecture notes, for instance, the equally weighted portfolio of the seven countries is inside the frontier. The reason was that the countries have different risk char-

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lecture07ps - Sauder School of Business Finance Division...

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