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1. (10 points) Consider the following analyst”s expected return on two stocks for two particular market returns. All states have an equal probability of occurring (probability of each state is 1/3). The risk-free rate is 2.5%. A. (4 points) What are the betas of the two stocks? (Hint: work out beta from the definition) b. (1 point) From our discussion in class or from intuition, what type of industry could Aggressive Stock represent and what type of industry could Defensive Stock represent? C. (2 points) According to the CAPM model, what is the expected return on each stock predicted to be in equilibrium (that is, what does CAPM say the expected return should be?) D. (2 points) According to CAPM, what are the alphas on each stock and what do these alpha values mean in terms of the stock being underpriced, overpriced or perfectly priced? E. (1 point) What strategies could you use to take advantage of these mispricings?
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