Assume the CAPM holds. Consider three feasible portfolios of stocks X, Y and Z with the following return characteristics:

(Stock, Portfolio Expected return, Standard deviation)

X 7.5% 5%

Y 5% 10%

Z 10% 15%

a) Explain why beta is the appropriate measure of risk in this world. (5 marks)

b) Portfolio Y is known to be uncorrelated with the market. Explain why this property implies that the risk-free rate in the economy is 5%. (5 marks)

c) It is known that one of the portfolios X, Y, Z lies on the efficient frontier (which includes the risk-free asset). Which portfolio is efficient? Explain/justify your answer. (5 marks)