Question

Consider the following two investors’ portfolios consisting of investments in four stocks:
Stock Beta Jack's Portfolio Nelson's Portfolio
A 1.3 $2,500 $10,000
B 1.0 $2,500 $5,000
C 0.8 $2,500 $5,000
D -0.5 $2,500 $2,500
Portfolio Expected Return 10% 9%
(a)
Calculate the beta on portfolios of Jack and Nelson respectively.

(b) Assuming that the risk-free rate is 4% and the expected return on the
market is 12%, determine the required return on portfolios of Jack and
Nelson respectively.

(c) From your answers in part (b), explain whether portfolios of Jack and
Nelson are over-priced, under-priced or correctly priced.

(d) State and explain whether the following statement is true or false:
“If a security lies above the security market line (SML), then it must be
over-priced.” (word limit: 150 words)

Answer 1

Stock	Beta	Jack	Nelson
A	1.3	2500	10000
B	1	2500	5000
C	0.8	2500	5000
D	-0.5	2500	2500
	Total	10000	22500
Portfolio beta is equal to weighted average beta
Jack	0.65
Nelson	0.922222222
b.As per CAPM, Required return = risk free rate + beta*(Market return - risk free return)
Jack	9.2	%
Nelson	11.37777778	%
c.
	Required Return	Expected Return	Status
Jack	9.2	10	Underpriced
Nelson	11.37777778	9	Overpriced
False, The security is underpried if it lies above SML as its expected return is higher than the required return on investor