The purpose of the problem is to help you walk through the main intuition of CAPM....

 

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The purpose of the problem is to help you walk through the main intuition of CAPM. To be able to do this exercise, you need to use all the variance and covariance properties (Make sure you are comfortable using all of these properties) Suppose that in this particular economy, there are four assets. Assets 1, 2, and 3 are risky and the fourth asset is risk-free. Note: The second part of this problem is difficult. Parts f)-1) are optional. The correlations of returns are described in the following table: Correlation Stock 1 Stock 2 Stock 3 Stock 1 1 0.6 0.7 And the standard deviation of the return of each stock is: Stock 1 Stock 2 Stock 3 0.3 0.6 0.25 Stock 1 Stock 2 Stock 3 Stock 2 0.6 1 0.2 Finally, the number of shares and price of each stock is: Price Number of Shares $10 100 $15 200 $10 200 Stock 3 0.7 0.2 1 a. Construct the variance-covariance matrix for the returns of the three risky assets. The purpose of the problem is to help you walk through the main intuition of CAPM. To be able to do this exercise, you need to use all the variance and covariance properties (Make sure you are comfortable using all of these properties) Suppose that in this particular economy, there are four assets. Assets 1, 2, and 3 are risky and the fourth asset is risk-free. Note: The second part of this problem is difficult. Parts f)-1) are optional. The correlations of returns are described in the following table: Correlation Stock 1 Stock 2 Stock 3 Stock 1 1 0.6 0.7 And the standard deviation of the return of each stock is: Stock 1 Stock 2 Stock 3 0.3 0.6 0.25 Stock 1 Stock 2 Stock 3 Stock 2 0.6 1 0.2 Finally, the number of shares and price of each stock is: Price Number of Shares $10 100 $15 200 $10 200 Stock 3 0.7 0.2 1 a. Construct the variance-covariance matrix for the returns of the three risky assets.

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