ST-5. 3. Portfolio expected return:

(.4x 12%)+(.25 x 11%)+(.35 x 15%)= 12.8%

Portfolio beta:

(.4 xl) + (.25 x .75) + (.35 x 1.3) = 1.04

b. Stocks 1 and 2 seem to be right in line with the security market line, which suggests that they are earning a fair return, given their systematic risk. Stock 3, however, is earning more than a fair return (above the security market line). We might be tempted to conclude that security 3 is undervalued. However, we may be seeing an illusion; it is possible to rnisspecify the security market line by using bad estimates in our data.

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16- 14- (%) 112 10- 10 return 00 Expected 9 2 Risk-free rate 0 0 0.5 1.0 1.5 Beta