Security a Has a Beta of 1

question 52

Essay

Security A has a beta of 1.0 and an expected return of 12%.Security B has a beta of 0.75 and an expected return of 11%.The risk-free rate is 6%.Explain the arbitrage opportunity that exists; explain how an investor can take advantage of it.Give specific details about how to form the portfolio, what to buy and what to sell.
B.The investor can accomplish this by choosing .75 as the weight in A and .25 in the risk-free asset.This portfolio would have E(r_p) = 0.75(12%) + 0.25(6%) = 10.5%, which is less than B's 11% expected return.The investor should buy B and finance the purchase by short selling A and borrowing at the risk-free asset.Feedback: The student can apply arbitrage principles.

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