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Tut8_2009_Solution

# Tut8_2009_Solution - BUS3026W Finance II 2009 Tutorial 8...

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BUS3026W Finance II 2009 - Tutorial 8 Due: Monday 4 May ______________________________________________________________ Question One Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75 and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage opportunity that exists; explain how an investor can take advantage of it. Give specific details about how to form the portfolio, what to buy and what to sell. [6] An arbitrage opportunity exists because it is possible to form a portfolio of security A and the risk-free asset that has a beta of 0.75 and a different expected return than security B.  The investor can accomplish this by choosing .75 as the weight in A and .25 in the risk-free asset. This portfolio would have E(r p ) = 0.75(12%) + 0.25(6%) = 10.5%, which is less than B's 11% expected return. The investor should buy B and finance the purchase by short selling A and borrowing at the risk- free asset. Marks should be awarded for any sound calculations illustrating the same final argument. Question Two You have decided to test the validity of the CAPM and have therefore calculated a large number of betas for a range of assets in the market. You have used the JSE’s All-Share Index as your measure of the market portfolio, but your findings indicate that there is no significant relationship between your asset returns and the calculated betas. Do your findings invalidate the CAPM? Why or why not? [5] Immediately, we have the problem that we are not testing the CAPM directly.

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