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

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 A B D Expected Return 10.00% 9.00% 14.00% 8.50% Total Return Variance 0.3844 0.5476 0.3600 1.4225 Firm Specific Variance 0.2548 0.4576 0.0000 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. 2. Suppose that asset C has a beta of 1 and is correctly priced. Is asset D correctly priced? If not, overpriced or underpriced? Show your calculation. 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 A B D Expected Return 10.00% 9.00% 14.00% 8.50% Total Return Variance 0.3844 0.5476 0.3600 1.4225 Firm Specific Variance 0.2548 0.4576 0.0000 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. 2. Suppose that asset C has a beta of 1 and is correctly priced. Is asset D correctly priced? If not, overpriced or underpriced? Show your calculation

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