Well-diversified portfolio A has a beta of 1.0 and an expected return of 12%. Well-diversified portfolio...

Well-diversified portfolio A has a beta of 1.0 and an expected return of 12%. Well-diversified portfolio B has a beta of 0.75 and an expected return of 9%. The risk-free rate is 4%. a. Assuming that portfolio A is correctly priced (has ?? = 0), what should the expected return on portfolio B be in equilibrium? b. Explain the arbitrage opportunity that exists and explain how an investor can take advantage of it. Give specific details about what to buy and what to sell.

Solutions

Expert Solution

1.
Expected return on portfolio B=4%+0.75*(12%-4%)=10.0000%

2.
As expected return on portfolio B should be 10% but it is actually 9%, the portfolio B is overvalued hence we should sell portfolio B.

Sell 1 unit of portfolio B
Buy 0.75 units of market portfolio
Buy 0.25 units of risk free rate

jeff jeffy answered 1 year ago

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