Quiz # 5 Question 1) Consider the regression equation: ri - rf = g 0 + g1bi + g 2σ e2i + eit where: ri - rt = the average difference between the monthly return on stock i and the monthly risk-free rate bi = the beta of stock i σ2ei = a measure of the nonsystematic variance of the stock i. If you estimated this regression equation and the CAPM was valid, you would expect the estimated coefficient, g2 to be A) 0 B) 1 C) equal to the risk-free rate of return D) equal to the average difference between the monthly return on the market portfolio and the monthly risk-free rate E) none of the above Ans: A Question 2) Consider a well-diversified portfolio, A, in a two-factor economy. The risk-free rate is 6%, the risk premium on the first factor portfolio is 4% and the risk premium on the second factor portfolio is 3%. If portfolio A has a beta of 1.2 on the first factor and .8 on the second factor, what is its expected return? A) 7.0% B) 8.0% C) 9.2% D) 13.0% E) 13.2% 1 Ans: E Question 3) 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. Ans: An arbitrage opportunity exists because it is possible to form a portfolio of security A and the risk-free asset that has a beta of 0.75 and a different expected return than security B. The investor can accomplish this by choosing .75 as the weight in A and .25 in the risk-free asset. This portfolio would have E(rp) = 0.75(12%) + 0.25(6%) = 10.5%, which is less than B's 11% expected return. The investor should buy B and finance the purchase by short selling A and borrowing at the risk-free asset. 2