1) Use the data below to answer the following:

Security Expected Return Standard Deviation

1 0.07 0.00

2 0.10 0.15

3 0.20 0.20

a) Assume 23 = -0.65 and your portfolio consists of security 2 and of security 3.

If your portfolio consists of 40% security 2 and 60% security 3, find the expected

return and standard deviation of your portfolio.

b) Now assume 23 = -1.00 and your portfolio consists of security 2 and of security

3.

Using the formulae for the minimum variance portfolio, provided below,

determine the portfolio weights that would give you the minimum standard

deviation portfolio.

X2 =

3

2 + 3

X3 =1 X2

c) On a graph, carefully plot the feasible set of portfolios of securities 2 and

3 if 23 = -1.00. Ensure that you identify security 2, security 3, and the minimum

variance portfolio.

2). Assume CAPM holds and that the risk free rate is 1% and that the expected return on

the market portfolio is 12%. Consider the following 2 capital asset portfolios that are out of

equilibrium (i.e., they do not fall on the Security Market Line (SML)):

Portfolio A: E[RA] = 15% A = 1.3

Portfolio B: E[RB] = 22% B = 1.85

a) Depict the risk-return trade-off in an illustration (in the space provided below) that includes the

Security Market Line (SML), and the 2 portfolios (A and B) the risk free security and the

market portfolio. Dont forget to label your axes.

b) Refer to each of the securities in your illustration in (a), and indicate (by circling) whether

the security is over-valued or under-valued, and whether investors will long or short the

asset.