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Assignment 4, FIN 310 Prof. Hanh Le Due at the start of class, Monday April 25, 2016 Read the following instructions carefully. Failure to follow these instructions will result in points being subtracted from your grade: (i) Write your answers in a separate clean sheet. Do not write on this document. (ii) If you work in a group, hand in only one submission. (iii) Write the names of all group members on your submission. (iv) Staple all answer sheets together. The Capital Asset Pricing Model 1. Assume the risk free rate equals Rf = 4%, and the expected return on the market portfolio is E [RM ] = 12% and standard deviation M = 15%. (a) What is the equilibrium market risk premium (that is, the expected return on the market portfolio minus the risk free rate)? (b) If a certain stock has a realized return of 14%, what can we say about the beta of this stock? (c) If a certain stock has an expected return of 14%, what can we say about the beta of this stock? 2. Apple stock has an average return of 12% and a beta of 1.1. Google stock has an average return of 14% and a beta of 1.2. The risk free rate is 5% and the expected return on the market is 10%. If you can only pick one stock to buy, which one would you pick? Explain your answer. Arbitrage 3. The stock PolarBear.com trades on both the South Pole Stock Exchange and the North Pole Stock Exchange. 1 (a) Suppose the price on the North Pole is $18. What does the No-Arbitrage Condition say about the price on the South Pole? (Assume no trading costs.) (b) Suppose the price on the North Pole is $18 and the price on the the South Pole is $17? How can you make an arbitrage prot? (Assume no trading costs.) (c) Suppose that the price on the North Pole is $18, that the cost of shorting is $2 and the cost of buying is $0 on both poles. What does the No-Arbitrage Condition say about the price on the South Pole? 4. All zero coupon bonds have a face value of $100. A one-year zero-coupon bond trades at $95. A two-year zero-coupon bond trades at $96. A three-year zero-coupon bond trades at $97. Answer the following questions: (a) Construct a replicating portfolio from the three zero-coupon bonds above to replicate cash ows of a 7% annual coupon bond with a face value of $100. (b) What is the equilibrium price of the 7% annual coupon bond given in part (a)? (c) If the 7% annual coupon bond is trading at a price of $110, show how you can make an arbitrage prot. 2