Question

9. You have two stocks in your portfolio, A and B. ??=1,??=1.4,?(??)=10%,?(??)=12%. You notice that there is a third stock in the market with expected return 13% and beta 1.2. You should
(a) Sell D (b) Buy D (c) Ignore D (d) None of the above

10. In question 9, what are the weights on A and B in the mimicking portfolio?
(a) 0.5, 0.5 (b) 0.3, 0.7 (c) 0.7, 0.3 (d) None of the above

11. Can the situation described in Question 9 be an equilibrium situation in the market
(a) No (b) Yes (c) None of the above

Answer 1

9)  A = 1   ; E(r_A) = 10%

A = 1.4 ; E(r_B) = 12%

Compare market excess return (MER) of both the securities as

E(r_A) = R_f + A * MER_A => 10% = R_f + 1*MER_A

E(r_B) = R_f + A * MER_B => 12% = R_f + 1.4*MER_B

Solving both equation, you will get MER_A = MER_B

Third Security:

D = 1.2 ; E(r_D) = 13%

E(r_D) = R_f + D * MER_D => 13% = R_f + 1*MER_D

Solving you will get, MER_D >MER_A

Thus, it will beneficial to buy third security.

10) Since MER_A = MER_B

Therefore, WA = WB i,e 0.5,0.5 in the mimicking portfolio.

11) Yes, this is the equilibrium situation in the market.