Demo Qs Topic 5 Part 2

# Demo Qs Topic 5 Part 2 - DEMONSTRATION LECTURE QUESTIONS...

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DEMONSTRATION LECTURE QUESTIONS TOPIC 5 RISK AND RETURN PART 2 QUESTION 1 a) If the expected return on the market is 12% while the risk-free rate is 5%, does the following description of securities constitute an equilibrium situation? Security Actual Return β i 1 15.5% 1.5 2 6.4% 0.2 3 1.5% -0.5 4 9.5% 0.8 5 14.8% 1.2 b) For those securities that are not in equilibrium, are the securities expected to rise in price or fall in price? SOLUTION Question 1 ( 29 r r r r i f m f i = + - β ( 29 ( 29 ( 29 m Equilibriu In % 5 . 15 5 . 1 5 12 5 r 1 = - + = ( 29 ( 29 ( 29 m Equilibriu In % 4 . 6 2 . 0 5 12 5 2 = - + = r ( 29 ( 29 ( 29 m Equilibriu In % 5 . 1 5 . 0 5 12 5 3 = - - + = r ( 29 ( 29 ( 29 m Equilibriu In Not % 6 . 10 8 . 0 5 12 5 4 = - + = r Actual Return is 9.5%, but CAPM predicts 10.6%. Price must fall so Return can rise to 10.6%. ( 29 ( 29 ( 29 m Equilibriu In Not % 4 . 13 2 . 1 5 12 5 5 = - + = r Actual Return is 14.8%, but CAPM predicts 13.4%. Price must rise so Return can fall to 13.4%.

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QUESTION 2 Asset A has an expect return of 10% and a beta of 1.2. Asset B has an expected return of 14% and a beta of 1.4 a) If the risk free rate is 6% what is the reward to risk ratio for Asset A? b) If the risk free rate is 6% what is the reward to risk ratio for Asset B? c) Expalin why Asset B is undervalued or overvalued compared to Asset A. SOLUTION QUESTION 2 NOTE : In calculating the numerator, which is the expected return minus the risk free rate, the forecast / expected rate is used not the equilibrium/required rate of return calculated from the CAPM. For if the equilibrium rate is used the reward to
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