Question

Is there an arbitrage opportunity given the following three portfolios (assume that CAPM holds)? If yes, construct an arbitrage portfolio. What is the portfolio expected return?

Portfolio	Expected return	Beta
A	16%	2
M	12%	1
F	4%	0

Answer 1

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Answer:

As beta is zero for F it must be risk - free stock

beta of M = 1=> stock is market specific

Rf = 4%

Return on stock = rf + beta(rm-rf)

=> Expected Return on A =Rf+beta*(return of market -rf)=4%+2*(12%-4%)=20%

As return is less than required return it is vaible to sell A buy M and F

For example:

Sell A and buy 2 times M and sell F

Sell A worth 100 to buy 200 worth of M and borrow 100 at F