Question 1 (Essential to cover)

Suppose the risk-free rate is 4% and that you believe in the estimates in the table below.

Asset

X Y M

E(r)

X 12.5% 30% 0.5

Y 19% 50% 1.5

M 16% 20% 1.0

1. Are assets X and Y correctly priced, and if not, what are their ?

2. Construct a portfolio that optimally exploits the mispricing.

3. How much did the squared Sharpe ratio of your optimal risky portfolio increase when you took the mispricing into account?

4. How much did the Sharpe ratio of your optimal risky portfolio increase when you took the mispricing into account?