Question

You complete an analysis of the fund DQXQ, and you expect an excess return (return - risk free) of 14.0%. Your expectation of the excess return of the market is 13.3%, and the beta of DQXQ is 0.85. You want to create an arbitrage portfolio to take advantage of the mispricing with the following characteristics (Wp, Wmkt, Wrf, alpha).

Group of answer choices

100% ; -85% ; borrow ; 15% ; 2.70%

-100% ; 85% ; lend ; 15% ; 2.70%

-100% ; 85% ; lend ; 15% ; 2.70%

-100% ; 85% ; lend ; 15% ; 0.70%

100% ; -85% ; borrow ; 15% ; 0.70%

Answer 1

As per the Capital Asset Pricing Model (CAPM), return from the fund should be = Market excess return*Beta

= 13.3%*0.85

= 11.30%

Since the return from fund (13.3%) is greater than the expected return, hence a 100% long position is to be taken in DQXQ fund and 85% short position on the market.

Alpha from this position is computed as follow:

Alpha = Excess fund return - Excess market return*Beta

= 14% - 13.3%*0.85

= 2.70%

Considering the fact that 100% long position is taken and 85% short position, borrowing to the extent of 15% is required for balancing the position.

Hence, as per the explanation provided above , the best group of answer choice is as follows:

100% ; -85% ; borrow ; 15% ; 2.70%