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IPM_Quize4(a)_Solution

# IPM_Quize4(a)_Solution - BUS 415 INVESTMENT AND PORTFOLIO...

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BUS 415: INVESTMENT AND PORTFOLIO MANAGEMENT SPRING 2011, AUBG Quiz 4(a) Problem 1 (10 points): Stock XYZ has an expected return of 12% and risk of β = 1. Stock ABC has an expected return of 13% and risk of β = 1.5. The expected return of market is 11%, and the risk-free rate is 5%. a. (3 points) According to the CAPM, which stock is a better buy? ] R ) R ( E [ R ) R ( E F M i F i - β + = % 11 %] 5 % 11 [ 0 . 1 % 5 ) R ( E XYZ = - + = % 14 %] 5 % 11 [ 5 . 1 % 5 ) R ( E ABC = - + = E(R XYZ ) = 11% requited vs. 12% actual E(R ABC ) = 14% requited vs. 13% actual Therefore, choose stock XYZ. b. (5 points) What is the alpha of each stock? Plot the SML and each stock’s risk- return point on the graph. ] R ) R ( E [ R ) R ( E F M i i F i - β + α = - % 1 %)] 5 % 11 ( 0 . 1 % 5 [ % 12 ( XYZ = - + - = α % 1 %)] 5 % 11 ( 5 . 1 % 5 [ % 13 ( ABC - = - + - = α So, XYZ stock is underpriced and ABC is overpriced. c. (1 points) The risk free rate if 8% now and the expected return on the market portfolio is 16%. A firm considers a project that is expected to have a beta of 1.4 What is the required rate of return on the project?

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