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# arbitrage opportunity that exists

5) If the expected returns for the risk-free asset and a risky asset are 4% and 17% respectively, what percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.11?

6) Discuss how the CAPM might be used in capital budgeting decisions and utility rate decisions.

7) Stocks A and B have the following characteristics:

Stock Expected Return Standard Deviation
A 10% 5%
B 15% 10%
Correlation = -1

Suppose that it is possible to borrow at the risk-free rate. What must be the value of the risk-free rate? (Hint: Think about constructing a risk-free portfolio from Stocks A and B and make use of the fact that the correlation is -1)

8) The index model for stock B has been estimated with the following result:

RB = 0.01 + 1.1RM + eB

If &#963;M = 0.2 and R2B = 0.5 what is the standard deviation of the return on stock B?

9) Security A has a beta of 1.0 and an expected return of 12%. Security B has a beta of 0.75 and an expected return of 11%. The risk-free rate is 6%. Explain the arbitrage opportunity that exists; explain how an investor can take advantage of it. Give specific details about how to form the portfolio, what to buy and what to sell.

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5) If the expected returns for the risk-free asset and a risky asset are 4% and 17% respectively, what percentages of your money must be invested in the risky asset and the risk-free asset, respectively, to form a portfolio with an expected return of 0.11?

Rf = 4%
And Rk = 17%
Rp = 11%
Let the share of risk-free asset to be Wf, then the share of risky asset is 1-Wf
We can construct the following equation:
Rp = Rf * Wf + Rk * (1-Wf)
or
11% = 4% Wf + 17% (1-Wf)
11% = 4% Wf + 17% - 17% Wf
0 = 6% - 13% Wf
Wf = 6% / 13% = 0.462 = 46.2%
Then the percentages of the risky asset = 1 - Wf = 53.8%

6) Discuss how the CAPM might be used in capital budgeting decisions and utility rate decisions.

The CAPM can be used to establish a hurdle rate for capital budgeting projects, based on the projects' ...

#### Solution Summary

This job overviews the arbitrage opportunity that exists. Stocks and the characteristics are analyzed.

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