You are considering a new investment which is expected to earn 12%. The beta of
ID: 2654518 • Letter: Y
Question
You are considering a new investment which is expected to earn 12%. The beta of this new investment is 0.6. Treasury Bills are earning 3%, and the S&P 500 is expected to earn 10%. Which one of the following statements is correct?
The alpha of the new investment is zero.
The new investment is underpriced.
The market risk premium is 9%.
The new investment has a negative alpha.
a.The alpha of the new investment is zero.
b.The new investment is underpriced.
c.The market risk premium is 9%.
d.The new investment has a negative alpha.
Explanation / Answer
The new investment is underpriced.
Since MRP would be = (Rm-Rf) = 10%-3% = 7% thus c is incorrect
ke= Rf + Beta(MRP) = 3% + .6*7% = 7.2% but it is expected to earn 12% as given. This means it is underpriced in the market.thus b is correct.
Since investment return is 12% which is greater than ke(7.2%) it means it has positive alpha.Thus a and d are incorrect.
b.The new investment is underpriced.
Since MRP would be = (Rm-Rf) = 10%-3% = 7% thus c is incorrect
ke= Rf + Beta(MRP) = 3% + .6*7% = 7.2% but it is expected to earn 12% as given. This means it is underpriced in the market.thus b is correct.
Since investment return is 12% which is greater than ke(7.2%) it means it has positive alpha.Thus a and d are incorrect.
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