The following table shows the expected return (E(ri)), the standard deviation (si), the correlation

with the market portfolio (ri;M), the market beta (bi), and the idiosyncratic risk

expressed as a standard deviation (se;i), for a number of assets, namely, the risk-free asset,

the market portfolio, and three risky stocks (1, 2, and 3). You can assume for this question

that the CAPM holds.

Asset E(ri) si ri;M bi se;i

Risk-free asset (rF)

Market portfolio (M) 10%

Stock 1 8% 15% 0.75

Stock 2 18% 80% 0.25

Stock 3 -4% 7.5% 0

(a) Fill in all the blanks in the table. Make sure you show your workings and the reasoning

behind the numbers you obtain.

(b) Given that Stock 3 has a negative expected return, why would an investor buy it? Could

Stock 3 be part of an efficient portfolio and why?

(c) Consider now a portfolio composed of the market M and stock 3. What weights should

we assign to these two assets in order to obtain a riskless portfolio? What will be the

expected return of this portfolio?