Question 2 [20 marks total]

Part A [5 Marks]

Why would an asset have a negative beta? Explain why it is appropriate for such an asset to have an expected return less than the risk-free rate.

Part B [5 Marks]

Consider a CAPM economy in which the risk-free rate is 4% p.a., the market risk premium is 7% p.a., and the standard deviation of the market portfolio is 20% p.a. XYZ is a stock that has a standard deviation of 30% p.a. The R-squared statistic in a regression of XYZ stock returns on market returns is 0.36. What is the expected return of XYZ?

Part C [5 Marks]

In a CAPM economy, investors should search for assets with a high Sharpe ratio. True or false? Explain.

Part D [5 Marks]

Aurizon Ltd operates the Central Queensland Coal Network, a rail network that is used to transport metallurgical coal (i.e., coal used in steel making) from various mines to various ports. This network has no alternative use. Most of the revenues are derived from six large mining companies. This means that the network is subject to stranding risk the risk that the coal price will fall such that one or more mines will cease using the network. Does this stranding risk have the effect of increasing the beta of the network?