V. Modern Portfolio Theory 1) How does diversification allow us to reduce portfolio risk? Explain using the formula for portfolio variance. 2) What is meant by an optimal portfolio? How is it related to an efficient portfolio? 3) A portfolio manager has derived tangency portfolio with E(T) = 16% 17%. The risk-free T-bill rate is 8%. and T = (a) What is the equation for the best feasible CAL? (b) You want your portfolio to be efficient with the highest Sharpe ratio. Furthermore you want an expected return of 14% on your portfolio. What is your portfolio standard deviation? VI. The Capital Asset Pricing Model a) Explain the CAPM equation E(rj) = r+j[E(rm) r]. b) Assume two stocks, Ford and General Mills, with respective beta risks 1.5 and 0.14. Assume further that the risk-free rate is 5% and the expected market return is 10%. Based on the CAPM what are the expected returns on the two stocks? Can you explain the difference in the expected returns of the two stocks?