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The risk free rate is 5%. The expected return on the market portfolio is 12%. Stock A has a beta of 0.7 and an expected return of 9%. Stock B has a beta of 0.9 and an expected return of 8%. Answer the following questions:
a. Draw the security market line. Label all relevant points (the expected returns and betas of the risk free asset and the market portfolio).
b. Is stock A fairly priced, according to the CAPM? Why or why not.
c. Indicate where stock A lies on the graph from part a.
d. Is stock B fairly priced, according to the CAPM? Why or why not.
e. Indicate where stock B lies on the graph from part a.
f. If you are an active portfolio manager, how do you trade in these two stocks? Explain your answer.
Continuing with our discussion of the importance of markets from last week, conduct an news search for an article related to the markets.
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