3. Assume that security returns are generated by the singleindex model Ri = i + iRM + ei , where Ri is the excess return for security i, and RM is the markets excess return. The riskfree rate is 3%. Suppose that there are three securities, A and B characterized by the table below

a. If M = .20, calculate the variance of returns of securities, A and B.

Security i /E(Ri), /% (ei), %

Stock A 1.25/12.5/25

Stock B 1.5/12/35

b. Now assume that there is an infinite number of assets with return characteristics identical to those of A and B, respectively. If one forms a well-diversified portfolio of type A securities, what will be the mean and variance of the portfolio excess returns? What about portfolios composed only of type B stocks?

c. Are there arbitrage opportunities in the market of question b? If so, what would be an arbitrage strategy?

d. Now consider a single security A from question a and a well diversified portfolio B from question b. Are there arbitrage opportunities in this market? If so, what would be an arbitrage strategy?