Assume that the following market model adequately describes the return-generating behavior of risky assets:
Rit = αi + βi RMt + εit
Rit = The return on the ith asset at Time t.
RMt = The return on a portfolio containing all risky assets in some proportion at Time t.
RMt and εit are statistically independent.
Short selling (i.e., negative positions) is allowed in the market. You are given the following information:

The variance of the market is .0121, and there are no transaction costs.
a. Calculate the standard deviation of returns for each asset.
b. Calculate the variance of return of three portfolios containing an infinite number of asset types A, B, or C, respectively.
c. Assume the risk-free rate is 3.3 percent and the expected return on the market is 10.6 percent. Which asset will not be held by rational investors?
d. What equilibrium state will emerge such that no arbitrage opportunities exist?Why?

  • CreatedAugust 28, 2014
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