Assume that stock market returns have the market index as a common factor

Question: Assume that stock market returns have the market i…

Assume that stock market returns have the market index as a common factor, and that all stocks in the economy have a beta of 1.4 on the market index. Firm-specific returns all have a standard deviation of 34%.

Suppose that an analyst studies 20 stocks, and finds that one-half have an alpha of +2.2%, and the other half an alpha of –2.2%. Suppose the analyst buys $1.0 million of an equally weighted portfolio of the positive alpha stocks, and shorts $1.0 million of an equally weighted portfolio of the negative alpha stocks.

1. What is the expected profit (in dollars) and standard deviation of the analyst’s profit? (Do not round intermediate calculations. Round your answers to the nearest whole dollar amount. Omit the “$” sign in your response.)

1. How does standard deviation change if the analyst examines 50 stocks instead of 20 stocks? 100 stocks? (Do not round intermediate calculations. Round your answers to the nearest whole dollar amount. Omit the “$” sign in your response.)