Problem 1:

The following table provides information on two risky stocks that you think, given some special information, are good investments.

StockExpected ReturnStandard Deviation

A.15.23

B.20 .18

The covariance between these two stocks is -.001.The expected return on the market is .15 with a standard deviation of .15.The risk-free rate is .03.You can borrow and lend at this risk-free rate.

You have $1,000,000 to invest.Some of this you may put in risk free T-bills (with a return of 3%), with the remainder invested in a portfolio of the two stocks above.Consider a portfolio that has 50 percent of the amount you put at risk in Stock A and 50 percent in Stock B.Call the portfolio that consists of Stock A and Stock B your risky portfolio.For this risky portfolio, answer the following questions.

a.What is the expected return of this risky portfolio?

b.What is the variance of the return on this risky portfolio?

c.What is the Sharpe measure for this risky portfolio?

d.You have a choice between forming a total portfolio of risk free investments and either the risky portfolio above or the risky market portfolio.Which of the following risky portfolios would you prefer to hold in your total portfolio:(1) the above 50%/50% portfolio with Stock A and Stock B or (2) the market portfolio?Explain why.

e.You have estimated the market betas of each of these individual securities, shown below.

StockMarket Beta

A.8

B1.2

According to CAPM, what should the expected returns on each of the two stocks equal?

Stock Expected Return (according to CAPM)

A___________________________

B ___________________________

Does this explain your answer to b above?Why or why not?