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23) Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B...

23) Portfolio A has a beta of 1.3 and an expected return of 21%. Portfolio B has a beta of .7 and an expected return of 17%. The risk-free rate of return is 9%. If a hedge fund manager wants to take advantage of an arbitrage opportunity, she should take a short position in portfolio ____ and a long position in portfolio ____.

Multiple Choice
A; B
B; A
B; B
A; A

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Answer #1
Expected return = Risk free rate + Market risk premium * Beta
Market risk premium = ( Expected return - Risk free rate ) / Beta
Market risk premium for A = ( 21% - 9% ) / 1.3 9.2%
Market risk premium for B = ( 17% - 9% ) / 0.7 11.4%
As the market risk premium is less of Stock A than Stock B, we will short A and Long B
Answer : A ; B
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