Market Model Assume that the market model is given by: R i,t = + R M,t +

Market Model Assume that the market model is given by:

R i,t = α + β R M,t  +  ε i,t In this equation, Ri,t represents the return on asset i at time t; RM,t represents the return on a portfolio containing all risky assets in the same proportion at time t; and both RM,t and εi,t are statistically independent variables. Short selling is allowed in the market. You are provided with the information set out in the table below:

Asset β Expected return (%) Var(εi,t)

A 0.7 8.41 0.0100 B 1.2 12.06 0.0144 C 1.5 13.95 0.0225 The variance of the market is 0.0121. Assume that there are no transaction costs.

(a) Calculate the standard deviation of returns for each asset.

(b) Calculate the variance of return of three portfolios containing an infinite number of asset types A, B or C, respectively.

(c) Assume the risk-free rate is 3.3 per cent and the expected return on the market is 10.6 per cent. Which asset will not be held by rational investors?

(d) What equilibrium state will emerge such that no arbitrage opportunities exist? Why?