According to the capital asset pricing model

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Reference no: EM131984097

Consider the following properties of the returns of Stock 1, of Stock 2 and of the market (m):

sd1 = 20%

sd2 = 30%

sd m = 15%

E(rme ) = 10%

correlation1,m = 0.4

correlation2,m = 0.7

where E(rme ) represent the excess return of the market portfolio. Suppose further that the risk-free rate is 5%.

1. According to the Capital Asset Pricing Model, what should be the expected excess return of Stock 1 and of Stock 2?

2. Suppose that a single index model that uses the market portfolio as a factor O¨ts well the data for the returns of Stock 1 and Stock 2. What can you learn about the correlation between the return of Stock 1 and the return of Stock 2?

3. What is the expected return and the standard deviation of the return of a portfolio P that has a 40% investment in Stock 1 and a 60% investment in Stock 2?

4. Using what you have learned in 3 about the portfolio P, would it be advisable to switch to a portfolio made up of the market portfolio and the riskfree asset? Why? (Hint: check the Sharpe ratio of the two portfolios).

Reference no: EM131984097

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