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Consider the following properties of the returns of Stock 1, of Stock 2 and of the market (m): 1 = 20% 1;m = 0:4 2 = 30% 2;m = 0:7 m = 15% E(r e m) = 10% ; where E(r e m) represent the excess return of the market portfolio. Suppose further that the risk-free rate is 5%.

Problem 1 (4 points) Consider the following propertics of the returns of Stock 1, of Stock 2 and of the market 1 = 20% 2-30% 'n = 15% E(%) = 10% P1,m = 0.4 P2-m-0.7 where E ( ) represent the excess return of the market portfolio. Suppose further that the risk-free rate is 5%. 1. According to the Capital Asset Pricing Model, what should be the expected excess return of Stock 1 and of Stock 2? Suppose that a single index model that uses the market portfolio as a factor fits well the data for the returns of Stock 1 and Stock 2. What can you learn about the correlation between the return of Stock 1 and the return of Stock 2? 3. What is the expected return and the standard deviation of the return of a portfolio P that has a 40% investment in Stock 1 and a 60% investment in Stock 2 4. Using what you have learned in 3 about the portfolio P, would it be advisable to switch to a portfolio made up of the market portfolio and the riskfree asset? Why? (Hint: check the Sharpe ratio of the two portfolios)

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