Question: Problem 1: There are 3 risky assets, and one is risk-free. A regression of asset returns on the market portfolio has yielded the following results:

Problem 1: There are 3 risky assets, and one is risk-free. A regression of asset returns on the market portfolio has yielded the following results:

Asset 1: r_1,t r_F = 0.09 + 1.5 (r_m,t R_F ) + _1,t

Asset 2: r_2,t r_F = 0.05 + 0.4 (r_m,t R_F ) + _2,t

Asset 3: r_3,t r_F = 0.1 + 1.2 (r_m,t R_F) + _3,t

You have estimated the expected returns on the assets as ₁ = 0.2, ₂ = 0.14, and ₃ = 0.16, respectively.

1. Explain, in as much detail as you can, how to estimate the Securities Markets Line (SML) from this information. Provide the necessary calculations. Draw a sketch of the SML, indicating within this the locations of the three assets and the market portfolio.

2. What inference (if any) would you draw from this estimation about the validity of the CAPM? Carefully explain your argument(s).

3. What inference (if any) would you draw regarding the performance of portfolios formed from the three assets? Carefully explain your argument(s).

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