Question 2 (Pricing and the CAPM – 5 marks) Wealthy Superannuation Fund decides to test if the shares in the five (5) companies are correctly priced. In an efficient market, the CAPM argues that the expected return and risk of a company share returns should lie on the security market line.

(a) Use the single index model (SIM) to estimate a; and Bi for each of the five (5) companies using their excess monthly share returns from June 2014 to June 2019. The equation below summarises the SIM, where Ri is the excess monthly return of stock i above the cash rate and Rm the excess monthly return of the ASX200. R; = a; + BiRM +&i List a; and Bi for each of the five companies in a simple labelled table, starting with the company that has the highest Bi. Note: Lectures 3 and 4 discuss how to do these calculations. The calculations can easily be done in EXCEL using formula functions or from a regression in “Data Analysis” (the “Y-range” is the dependent variable, the column of excess stock return, and “X-range” is the independent variable, the column of excess ASX200 returns). (worth 0.5 marks)

(b) In a simple labelled table list the expected excess returns for each of the five companies. Your calculations must be done under the assumptions of the SIM. (worth 0.5 marks)

(c) To test if the five (5) companies are correctly priced Wealthy Superannuation Fund runs the following regression, where Ri is the estimated expected excess return of each company and B; is the beta coefficient of each company: R; = a +yBi + Ei Run this regression using the Bis and expected Ris that you estimated in (a) and (6) for all five of the companies. In a simple labelled table list the estimates for a and y as well as their p values and t statistics. Explain what these estimates say about the relationship between R and Bi. Note: The regression can be done in “Data Analysis” (the “Y-range” is the dependent variable, the column of expected excess stock returns and “X-range” is the independent variable, the column of betas). (worth 1 mark)

(d) Are any of the five (5) companies mispriced? To answer this question, you need to:

a. Plot the best-fitted line for the estimated Bis and expected Ris and show the position of the five companies on the graph. Note: The plot can be generated when doing the regression in “Data Analysis” by selecting the best line fit plots. (worth 0.5 marks)

b. In a simple labelled table show the difference between the estimated expected Ris calculated in (b) and the Ri for each company according to the companys beta estimated in (a) and a and y estimated in (c). (worth 0.5 mark)

c. Explain how and why the companies are mispriced. (worth 1 mark)

(e) Identify any potential arbitrage trading opportunities that Wealthy Superannuation Fund could use to generate a profit. Describe these trades and how they can be profitable. (worth 1 mark)