Assume that new biotechnology companies have an average P-E ratio of 600, and will grow to companies comparable to S&P 500 companies in 10 years. The companies in the S&P 500 have an average P-E ratio of 30. The discount rate (investors' required rate of return), R = 0:10.

What is the market's forecast of return on equity, ROE, for new biotechnology companies? Is this a reasonable expectation?

Suppose that we have two stocks A and B, with information as follows:

Stock Expected return Standard Deviation

A 20% 30%

B 12% 15%

The correlation coefficient between returns of stock A and stock B is 0.1. What are the investment proportions (portfolio weights) in the minimum-variance portfolio of the two stocks, and what is the expected value and standard deviation of the portfolio's rate of return?

Suppose that two stocks, A and B, have the same beta = 1. The standard deviations of

the idiosyncratic returns for the two stocks, A and B, are the same and equal to 30% (Using

the notation in our class, A = B = 30%). Suppose that an analyst uses CAPM to study

the two stocks, and nds that stock A has an alpha of 2% and the stock B has an alpha of

2%. Suppose the analyst buys $10,000 of stock A, and short sells $10,000 of stock B.

(Hint: If CAPM holds, then expected return of any stock i is Ri = i +Rf +i(Rm Rf )+

i. Rf is the risk-free return, Rm is the market return and i is the idiosyncratic return.

The expectation of the idiosyncratic return for any stock is equal to 0%. Think about the

covariance of idiosyncratic returns for any two stocks.)

5. What is the expectation and standard deviation of the analyst's prot (in dollars)?