QUESTION 3. [{CALCNS a. + b. + c. = (3 + 3) + (2 + 2 + 4) + 2 = 16 marks} + {RECNS d. = 2 marks}] a. Historical data for the All Ordinaries Index indicates that: - the standard deviation of returns from the Index has been 17%; and - the degree of risk aversion (A) of an investor in the Index is 3.6. REQUIRED: i. What market risk premium is consistent with the above historical standard deviation? ii. If the market risk premium is 12%, what would be the historical standard deviation? b. The expected return of the market in Iceland is 15%. Stock H has a beta of 1.3 and the risk-free rate is 5%. REQUIRED: i. What is the expected return of Stock H, according to the CAPM? ii. What is the alpha of a stock? (Definition or explanation required.) iii. What is the alpha of Stock H, if Iceland Stockbrokers, investors in - and researchers of - the stock, believe that Stock H will provide a return this year of: I. 20%; or alternatively, if they consider the return this year will be: II. 14%?

c. Based on your answers to part b. iii. above, is Stock H over-priced, underpriced or fairly priced in each of the situations I. and II.? Would you recommend that Iceland Brokers buy more of or sell or just hold Stock H in each of these situations? d. Jackie, an analyst with Betta Brokers, uses a two-factor (F1 and F2) CAPM index method to evaluate the expected return of stock in Z Ltd. The model uses the following data: E(R) of F1 = 12%; E(R) of F2 = 8%; (beta) of F1 = 1.3; (beta) of F2 = 0.4; and Rf (risk-free rate) = 5%. What is the expected return of a share in Z Ltd?