You are given the following information about stock x

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15) You are given the following information about Stock X, Stock Y and the market (i) The expected return and volatility for Stock X, Stock Y and the market are shown in the table below: (ii) The correlation between the returns of stock X and the market is –0.25. (iii) The correlation between the returns of stock Y and the market is 0.30. Calculate the required return for Stock Y. (A) 1.48% (B) 2.52% (C) 3.16% (D) 4.84% (E) 6.52% Required Return Volatility Stock X 3.0% 50% Stock Y ? 35% Market 6.0% 25%
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IFM-02-18 31 Key: D Begin by using information about Stock X to determine the risk-free rate. For Stock X, β = –0.25*(50%/25%) = –0.50. The required return is 3% = r f – 0.50*(6% – r f ) = –3% + 1.5*r f . Thus, r f = 6%/1.5 = 4%. For Stock Y, β = 0.30*(35%/25%) = 0.42. The required return is 4% + 0.42*(6% – 4%) = 4% + 0.84% = 4.84%. Reference: Berk/DeMarzo, Section 11.6
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IFM-02-18 32 16) You are given the following information about Stock X and the market: (i) The risk free rate is 5%. (ii) The expected return and volatility for Stock X and the market are shown in the table below: (iii) The correlation between the returns of stock X and the market is –0.25. Calculate the required return for Stock X and determine if the investor should invest in Stock X. Expected Return Volatility Stock X 5% 40% Market 8% 25%
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IFM-02-18 33 Key: C β = –0.25*(40% / 25%) = –0.40. The required return is 5% - (0.40)*(8% – 5%) = 5% – 1.2% = 3.8%. The expected return for Stock X is 5%, which exceeds the required return of 3.8%, so the investor should invest in stock X. Reference: Berk/DeMarzo, Section 11.6
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IFM-02-18 34 17) Determine which one of the following statements regarding multi-factor models is NOT true.
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IFM-02-18 35 Key : C Neither taxes nor transaction costs need be considered in a multi-factor model. Reference: Berk/DeMarzo, Section 13.7
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IFM-02-18 36
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