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.