1. How do the models (Efficient Frontier and Capital Asset Pricing Model) define risk? define return? HINT: Dig out the specific definitions for each model to demonstrate the similarities and differences in the definitions between models.
2. Look at the Efficient Frontier diagram, and explain how you might use it to make investment decisions. HINT: Briefly state what the diagram tells you, then make a judgment about its practical application to investing for investors who are risk averse but still want to maximize their rates of return.
3. If the rate of return on the S&P 500 index was 23% for 2009, and the risk-free rate at the end of 2009 was 1%, calculate the equity risk premium for 2009? Recalculate the equity risk premium using 1981 data, when the risk free rate was 15% and the S&P 500 index return was minus 10%. What are the implications of different equity risk premia numbers for different time periods? HINT: When you use the CAPM, you must enter an equity risk premium. Therefore, how do you do that accurately when data for different years produce different equity risk premia?