3. Capital Asset Pricing Model

(a) Explain the principle of diversification.

(b) Define the risk premium of a stock.

(c) State the Capital Asset Pricing Model (CAPM) identity that relates a stocks riskpremium to the market risk premium.

(d) Consider the following: Stock 1: (R1) = 0.20

Stock 2: (R2) = 0.30 Market Portfolio: (M) = 0.15, E(RM) = 0.10

Riskfree rate: Rf = 0.05

Correlation: (R1, RM) = 0.4, (R2, RM) = 0.7According to CAPM, what should be the risk premium of Stock 1 and of Stock 2?