1.i) Suppose that there are many different companies whose stocks have the same beta, say 1. Can you form a portfolio to diversify the risk to get a lower beta?

ii) Single factor model. Suppose that the single factor model for stocks A and B is estimated from excess returns as follows

R^e_A = 3% + 0.7R^e_M + _A

R^e_B = 2% + 1.2R^e_M + _B

where, _M = 20% , R-squared of A is 20% and R-squared of B is 12%.

(a) What is the standard deviation of each stock?

(b) Break down the variance of each stock into its systematic and firm-specific components.

(c) Calculate information ratio of each stock.

(d) What are covariance and the correlation coefficient between the two stocks?

(e) What is the covariance between each stock and the market index? (f) What is the standard deviation and market beta of portfolio P with weights of 0.60 in A and 0.40 in B ?