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Suppose the return on portfolio P has the following probability distribution:
Bear market Normal market Bull market
Probability 0.2 0.5 0.3
Return on P -20% 18% 50%
Assume that the risk-free rate is 5%, and the expected return and standard deviation on the market portfolio M is 0.15 and 0.20, respectively. The correlation coefficient between portfolio P and the market portfolio M is 0.8.
1. Is P efficient?
2. What is the beta of portfolio P?
3. What is the alpha of portfolio P? Is P overpriced or underpriced?
Hint: a = Actual expected return - Required return (given risk)
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