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Lecture 3

ADM2337 Lecture 3: Untitled3

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Catherine Elliott

Example 10 (problem 7-13): You plan to invest in a hedge fund that has total capital of $500 million invested in 5 stocks: Stock Investment (in million) Stock’s Beta A 160 0.5 B 120 2.0 C 80 4.0 D 80 1.0 E 60 3.0 The risk-free rate is 6%, and you believe that the following probability distribution for future market returns is realistic: Probability Market Return 0.1 7% 0.2 9% 0.4 11% 0.2 13% 0.1 15% The hedge fund receives a proposal from a company seeking new capital. The amount needed to take a position on the stock is $50 million. The stock has an expected return of 15% and its estimated beta is 2.0. Should the hedge fund invest in the new company? At what expected rate of return should the fund be indifferent to purchasing the stock? Solution: =500mln Current beta of this hedge fund is -=0.16+0.48+0.64+0.16+0.36=1.8, Market return can be estimated to be: =0.007+0.018+0.044+0.026+0.015=0.110 or 11% Thus fund’s current expected return (using CAPM) should be =0.15 or 15% New stock has beta=2, so, return on it should be =0.16 or 16%. Example 11 (problem
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