Assume you have invested in two other stocks: Stock A has a beta of 1.20 and Stock B has a beta of 0.8. R_f= 2% and R_m= 12%.

• Using CAPM, what are the expected returns for each stock?

Return of stock = Risk free rate + beta ( market rate of return - risk free rate of return)

Return of Stock A = 2% + 1.20 (12% - 2%) = 2.12%

Return of Stock B = 2% + 0.80 (12% - 2%) = 2.08%

• What is the expected return of an equally weighted portfolio of these two stocks?

Weight of stock A = 0.50

Weight of Stock B = 0.50

Expected return = (Return of Stock A * weight of Stock A) + (Return of Stock B * weight of stock B)

= (2.12 * 0.50) + (2.08*0.50)

= 1.06 + 1.04 = 3%

• What is the beta of an equally weighted portfolio of these two stocks?

Beta of portfolio = (Beta of Stock A * weight of stock A) + (Beta of Stock B * weight of Stock B)

= (1.20*0.50) + (0.80*0.50)

= 0.60 + 0.40 = 1

Beta of portfolio = 1

(iv) Sketch the SML to represent the markets expected return (Please do this one)

(v) Place Stock A and B on the SML and state if they are over- valued or Under-valued. (Please do this one)