Index model: You identify a portfolio of energy stocks. According to your analysis, the portfolio has a beta of 0.75 and an expected return of 4.5%. The expected return of the market is 6.5% and the risk- free rate is 0.5%. The portfolio only includes a few stocks (it is not well diversified) and therefore has both market and firm specific risk.
a. What is the expected return of this portfolio as predicted by the SML?
b. What is the portfolio’s alpha? Is the portfolio overpriced or underpriced?
c. What is the equation for the rate of return of the trading strategy that exploits current conditions and eliminates market risk?