Question

Question 5 A new financial asset is priced at $110 per share. In one year, the payoff may be $150 with 70% probability and $90 with 30 % probability. The following information is gathered for current situation: • • • The expected market rate of return is 25 %. The standard deviation of the market return is 30 %. The risk-free rate is 6%. It is estimated that the payoff of the new asset is correlated with the market return at coefficient of 0.6. (a) Solve for the price of the financial asset predicted by CAPM? (9 marks) (b) Is this asset a good buying? (Give brief reason.) (2 marks) (c) Interpret if the financial asset is efficient. (9 marks)

Answer 1

1.
expected returns of asset=0.70*(150/110-1)+0.30*(90/110-1)=0.20000

standard deviation of asset's returns=sqrt(0.70*(150/110-1-0.20)^2+0.30*(90/110-1-0.20)^2)=0.25

beta=correlation*standard deviation of asset/standard deviation of market=0.6*0.25/0.30=0.50000

required return=risk free rate+(market return-risk free rate)*beta=6%+(25%-6%)*0.5=15.500%

Price=0.7*150/1.155+0.3*90/1.155=114.28571

2.
Yes as price is less than the fair value predicted by CAPM

3.
Expected return=20%
No it is not efficient as expected return is less than required return