ou consider investing in a stock. You think that the stock has an
expected return of 9.5% and the risk-free rate of return is 1%. However,
when you use the CAPM equation, you find that the stock’s alpha is
-0.5%. This is due to the stock’s large exposure to the market, with a
market beta of 2.
(a) Explain briefly whether it is a good or bad idea to buy the stock
(according to the CAPM).
(b) Based on the above information, what is the expected return on
the market?
(c) (!) Does your answer to (a) change if the risk-free rate of return
at which you can borrow is 1% higher than the risk-free rate of
return at which you can lend? Assume that the expected return
of the stock is unchanged at 9.5%. Hint: if you want to get a beta
of 2, what would be the expected return of the tracking portfolio?