Question $1(10$ marks$)$

You are using the capital asset pricing model $($CAPM$)$ with focus on the security market line $($SML$)$ and its use in security selection.

The risk$-$free rate is $7\%.$

The market risk premium was $5\mathrm{.}5\%$ last year.

The standard deviation of market returns is $35\%.$

This year, the market risk premium is estimated to be $7\%.$

a$)$ You are evaluating stocks A and B using the following information: Stock A has a beta of $1\mathrm{.}30$ and is expected to generate a $15\mathrm{.}5\%$ return. The covariance of Stock B with the market is $0\mathrm{.}18.$

The standard deviation of Stock B$\text{'}$s returns is $41\%.$

Stock B has an expected return of $17\%$ return.

Provide investment recommendation on stocks A and B$.(5$ marks$)$