II. For the following questions, show all your workings:

31. The risk free rate is 5%. The expected return on the market portfolio is 12%. Stock A has a beta of 0.7 and an expected return of 9%. Stock B has a beta of 0.9 and an expected return of 8%. Answer the following questions:

a. Draw the security market line. Label all relevant points (the expected returns and betas of the risk free asset and the market portfolio).

b. Is stock A fairly priced, according to the CAPM? Why or why not.

c. Indicate where stock A lies on the graph from part a.

d. Is stock B fairly priced, according to the CAPM? Why or why not.

e. Indicate where stock B lies on the graph from part a.

f. If you are an active portfolio manager, how do you trade in these two stocks? Explain your answer.