Question: Suppose that the relevant equilibrium model is CAPM and the risk-free rate is 4%. Total return variance of a stock return could be decomposed into

Suppose that the relevant equilibrium model is CAPM and the risk-free rate is 4%. Total return variance of a stock return could be decomposed into systematic (i.e. market risk) variance and firm specific variance. Consider the following assets:

Asset

Expected Return

Total Return Variance

Firm Specific Variance

A

10.00%

0.3844

0.2548

B

9.00%

0.5476

0.4576

C

14.00%

0.3600

0.0000

D

8.50%

1.4225

0.8600

  1. A risk-averse investor with a well-diversified portfolio is considering adding asset A or asset B to his/her portfolio. S/he would like to choose the one with lower systematic risk. Which asset would you recommend? Show your calculations.

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