Assume that the following two assets are priced according to the zero-beta security market line: asset 1 has an expected return of 6% and beta 0.5; asset 2 has an expected return of 14% and beta 2. 

(i) A third asset is mispriced by the market: it has a beta of 1.5 and an expected return of 8%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such a portfolio? [33%] 

(ii) A fourth asset is mispriced by the market: it has a beta of 1.2 and an expected return of 18%. Explain how you can set up a portfolio to exploit the arbitrage opportunity. What is the expected return of such a portfolio? [33%] 

(iii) What should be the expected return for an asset with beta 0.8?

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Answer i A portfolio with weight w1 in asset 1 weight w2 in asset 2 and weight w3 in asset 3 will ha... View the full answer