Question 1 Portfolio Theory and CAPM (9 marks) You purchased 2,000 shares of Stock A at price of $1.00 per share and 1,000 shares of Stock B at price of $2.00 per share. Stock A has a beta value of 1.5, an expected return of 20% and a standard deviation of 30%; and Stock B has a beta value of 0.8, an expected return of 8% and a standard deviation of 20%. The correlation coefficient between the two stock returns is 0.2. The risk-free rate is 4% and the market risk premium is 7%.

(a) What are the investment proportions in your portfolio with the two stocks at the time when you purchased their shares? (1 mark)

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(b) Calculate the expected return, the standard deviation of returns, and the beta value for your two-stock portfolio. (3 marks)

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(c) Determine whether each of the two stocks is mispriced according to the CAPM. If a stock is mispriced, you need to indicate whether it is over-priced or under-priced. (3 marks)

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(d) Draw the security market line (SML) and represent Stock A, B, and your two-stock portfolio (denoted as P) in the graph of SML. (Note: A hand drawn graph of SML is acceptable.) (2 marks)