Kindly answer the following about Capital Asset Pricing Model
1. a. John Wilson is a portfolio manager at Austin & Associates. For all of his clients, Wilson manages portfolios that lie on the Markowitz efficient frontier. Wilson asks Mary Regan, CFA, a managing director at Austin, to review the portfolios of two of his clients, the Eagle Manufacturing Company and the Rainbow Life Insurance Co. The expected returns of the two portfolios are substantially different. Regan determines that the Rainbow portfolio is virtually identical to the market portfolio and concludes that the Rainbow portfolio must be superior to the Eagle portfolio. Do you agree or disagree with Regan’s conclusion that the Rainbow portfolio is superior to the Eagle portfolio? Justify your response with reference to the capital market line.
b. Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater nonsystematic risk than Eagle’s portfolio. Define nonsystematic risk and explain why you agree or disagree with Wilson’s remark.
2. Wilson is now evaluating the expected performance of two common stocks, Furhman Labs Inc. and Garten Testing Inc. He has gathered the following information:
?? The risk-free rate is 5%.
?? The expected return on the market portfolio is 11.5%.
?? The beta of Furhman stock is 1.5.
?? The beta of Garten stock is .8.
Based on his own analysis, Wilson’s forecasts of the returns on the two stocks are 13.25% for Furhman stock and 11.25% for Garten stock. Calculate the required rate of return for Furhman Labs stock and for Garten Testing stock. Indicate whether each stock is undervalued, fairly valued, or overvalued.