QUESTION 12 (30 Marks) a) You are constructing a diversified portfolio. Among the companies you are considering are ABC Ltd (expected return 16.5%, standard deviation 30%, beta 1.5) and XYZ Ltd (expected return 13.8%, standard deviation 32%, beta 1.2). Should you be considering XYZ as part of your portfolio when XYZ is inefficient relative to ABC? Explain theory behind your answer. (6 marks) b) Consider three stocks: Q, R, and S. Beta Forecast for the next year Standard deviation (annual) Stock price Dividend $0.50 Q 0.45 35% 40% $45 R 0 $75 1.45 -0.20 S 40% $1.00 $20 Use a risk-free rate of 2% and an expected market return of 9.5%. The market's standard deviation is 18%. Assume that the next dividend will be paid in one year. What should today's price be for each stock, assuming the CAPM is correct? The return on a dividend paying stock between time t-1 and t is calculated as Rt-1,t=(Pr+D-Pt-1)/Pt-1. (7 marks) c) Expected returns and standard deviations of three risky assets are as follows: A B C Expected returns 11% 14.5% 9% Standard deviation 30% 45% 30% Correlations A B 1.0 0.3 0.15 0.3 1.0 0.45 0.15 0.45 1.0 Compute the Sharpe ratio of a portfolio that has 30% in A, 30% in B and 40% in C. The risk- free interest rate is 4%. (7 marks) d) Describe step-by-step how you would test for the CAPM model using real data? Provide a rationale behind the test. (10 marks)