Question

Assume that the following two assets are priced according to the zero-beta security market line: asset 1 has expected return of 6% and beta 0.5; asset 2 has expected return 14% and beta 2. (i) A third asset is mispriced by the market: it has beta 1.5 and expected return of 8%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such portfolio? [33%] (ii) A fourth asset is mispriced by the market: it has beta 1.2 and expected return of 18%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such portfolio? [33%] (iii) What should be the expected return for an asset with beta 0.8?

          Assume that the following two assets are priced according to the
zero-beta security market line: asset 1 has expected return of 6%
and beta 0.5; asset 2 has expected return 14% and beta 2. (i) A
third asset is mispriced by the market: it has beta 1.5 and
expected return of 8%. Explain how you can set up a portfolio to
exploit the arbitrage opportunity. What is the expected return of
such portfolio? [33%] (ii) A fourth asset is mispriced by the
market: it has beta 1.2 and expected return of 18%. Explain how you
can set up a portfolio to exploit the arbitrage opportunity. What
is the expected return of such portfolio? [33%] (iii) What should
be the expected return for an asset with beta 0.8?

Added by Katherine W.

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