Question: Assume that security returns are generated by the single-index model, Ri = i + iRM + ei where Ri is the excess return for security

Assume that security returns are generated by the single-index model, Ri = i + iRM + ei where Ri is the excess return for security i and RM is the markets excess return. The risk- free rate is 2%. Suppose also that there are three securities, A, B, and C, characterized by the following data: Security i E(Ri) Standard Deviation A 0.8 10% 25% B 1.0 10% 20% C 1.2 14% 20% (a) [10pts] If M = 20%, calculate the variance of returns of securities A, B, and C. (b) [10pts] Now assume that there are an infinite number of assets with return character- istics identical to those of A, B, and C, respectively. If one forms a well-diversified portfolio of type A securities, what will be the mean and variance of the portfolios excess returns? What about portfolios composed only of type B or C stocks? (c) [10pts] Is there an arbitrage opportunity in this market? What is it? Analyze the opportunity graphically

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