Consider the following properties of the returns of Stock 1, of Stock 2 and of the market (m):
sd1 = 20%
sd2 = 30%
sd m = 15%
E(rme ) = 10%
correlation1,m = 0.4
correlation2,m = 0.7
where E(rme ) 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?
2. Suppose that a single index model that uses the market portfolio as a factor O¨ts 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).