Problem 2:

a. Consider the following data on the returns of the following firms. Fill in the blanks on the following table assuming that CAPM holds.

SD

Beta Expected return of Return

Firm A .5 ___________ .25

Firm B __________ .10 .35

Firm C .75 .09 .40

Market _________ .11 .30

Risk-free Bond __________ ___________ 0

The correlation between the returns on Firm A and Firm B is .45.

1. Consider a portfolio in which you invest $25,000 in the stock of Firm A and $75,000 in the stock of Firm B. Using the data from part a. above, fill in the following table.

Expected Return on the portfolio: ________________

Beta of the portfolio: ________________

NOTE: the beta of a portfolio is just the weighted average of the individual betas, with weights equal to the weight in each security in the portfolio.

Variance of the portfolio return: ________________

Sharpe Ratio of the portfolio: ________________

1. If you can also invest at the risk-free rate, which risky portfolio would you prefer to have as your risky portfolio: the portfolio of A and B or the market portfolio? Explain why.

1. Which of the two firms A or B has greater correlation with the market? Explain why.