b You have the following information of expected returns and

b. You have the following information of expected returns and betas for six assets. Assume CAPM is valid and asset X and asset Y are priced correctly. Asset Expected Return Beta 10.51 . 15.06 17.28 21.34 24.59 26.54 0.93 1.58 1.95 2.26 2.75 3.22 G) Which asset(s) is/are overpriced? Which asset(s) is/are underpriced? Please explain (22 marks) your answer in detail. (Gi) After studying the information above, Anna tells you that she can construct a portfolio containing assets A and C that would outperform asset B. Is Anna correct? Show your calculation to prove whether Anna is correct or not. (15 marks)

Solution

(i)

as per CAPM model

Expected return = R_f  + B_eta (R_{m -} R_f)

since it is said X and Y perfectly priced

10.51% (Ex ) =   R_f  + B_{eta 1} (R_{m -} R_f)

15.06% (Ey) =   R_f  + B_eta2 (R_{m -} R_f)

on solving both

(beta2 - beta1) (Rm - Rf) = 4.55%

Rm - Rf = 7%

substituting the Rm - Rf value of 7% in any of the above equation fetches

Rf = 10.51% - 0.93(7%) = 4%

Rm = 4% + 7% = 11%

asset as per CAPM expected return over/underpriced

A   4% + 1.95*7% = 17.65% 17.28% overpriced

B   4% + 2.26*7% = 19.82% 21.34% underpriced

C 4% + 2.75*7% = 23.25% 24.59% overpriced

D 4% + 3.22*7% = 26.54% 26.54% perfectly priced

(ii)

let x in C

so 1 - x in A

x(beta C) + (1 - x)(beta A) = beta _B

2.75x + 1.95 - 1.95x = 2.26

x = 0.3875

1-x = 0.6125

investing in A and C in the same proportion fetch

0.3875*24.59% + 0.6125*17.28% = 20.11%

investing in B is better than constructing portifolio using A and C since for same level of beta B is giving higher return than A and C. hence Anna decision is wrong.