PROBLEM SET 7

1) Suppose that the risk-free rate is 4% and that you believe in the estimates
in the table below.

Asset E(r)
X 12.5% 30% 0.5
Y 19% 50% 1.5
M 16% 20% 1

(a) Are assets X and Y correctly priced, and if not, what are their ?
(b) Construct a portfolio that optimally exploits the mispricings.
(c) How much did the squared Sharpe ratio of your optimal risky portfolio
increase when you took the mispricings into account?
(d) How much did the Sharpe ratio of your optimal risky portfolio increase
when you took the mispricings into account?

2) The data in the table below was estimated using returns for the period 2001
to 2011.

rM rf rSM B rHM L rM OM
E(r) 2.7% 5% 4.1% 1.3%
M ICROSOF T,f actor 1 -0.25 -0.67 -0.15
COCACOLA,f actor 0.6 -0.23 -0.08 0.15
CHEV RON,f actor 1 -0.46 0.33 -0.4
GE,f actor 1.1 -0.21 0.19 -0.26

(a) What can you conclude about the performance of stocks with high book-
to-market ratios relative to stocks with low book-to-market ratios?
(b) What can you conclude about the book-to-market ratio of Microsoft?
(c) Can you conclude that you should invest all your money in the SMB
portfolio?
(d) Suppose that the risk-free rate is 2%. What is the expected return of
Chevron?