Consider the following information about the various states of economy and the returns of various investment alternatives for each scenario. Answer the questions that follow. % Return on T-Bills, Stocks and Market Index State of the Economy Probability T- Bills Phillips Payup Rubbermade Market Index Recession 0.2 7 -22 28 10 -13 Below Average 0.1 7 -2 14.7 -10 1 Average 0.3 7 20 0 7 15 Above Average 0.3 7 35 -10 45 29 Boom 0.1 7 50 -20 30 43 Mean Standard Deviation Coefficient of Variation Covariance with MP Correlation with Market Index Beta CAPM Req. Return Valuation (Overvalued/Undervalued/Fairly Valued) Nature of stock (Aggressive/Defensive) Question 1 (18 marks) Fill the parts in the above table that are shaded in yellow. You will notice that there are nine line items. Each line item is worth 2 marks Question 2 (8 marks) Using the data generated in the previous question (Question 1); a) Plot the Security Market Line (SML) (2 marks) b) Superimpose the CAPM’s required return on the SML (2 marks) c) Indicate which investments will plot on, above and below the SML? (2 marks) d) If an investment’s expected return (mean return) does not plot on the SML, what does it show? Identify undervalued/overvalued investments from the graph (2 marks) Question 3 (4 marks) From the information generated in the previous two questions; a) Identify two investment alternatives that can be combined in a portfolio. Assume a 50- 50 investment allocation in each investment alternative (1 mark) b) Compute the expected return of the portfolio thus formed (1 mark) c) Compute the portfolio’s beta. Is the portfolio aggressive or defensive? (2
