Question 2 (25 marks)

Assume the risk-free rate is 3% and the market return is 10%.

	Stock X	Stock Y	Stock Z
Beta	---	0.65	0.90
Current price	$13.50	$26.50	---
Correlation	(X/Y)=0.35	(X/Z)=0	(Y/Z)=0.55

a) Most equity research concludes that Stock X is much more volatile compared to the market. On average, Stock Xs volatility is about 1.5 times that of the stock market. Based on CAPM, estimate the required return of Stock X. (5 marks)

b) It is expected that Stock Y will pay a per share dividend of $0.43 one year from now, and the dividend will increase by an average of 6% per year in the foreseeable future. According to CAPM, is Stock Y overvalued or undervalued? (9 marks)

c) Assume that Stock Z is fairly-priced today. Stock Z has just paid a dividend of $2. It is expected that its dividend will increase by 50% in the first year, 0% in the second year, 10% in the third year, and starting from the fourth year, the company will maintain the dividend growth rate to be 5% forever. How much would Stock Z be worth today if its required rate of return is 10% per year? (9 marks)

d) Which pair of stocks (refer to the bottom row of the table) used to form a 2-asset portfolio would achieve the largest diversification effect? Explain the answer. (2 marks)