Exercise 2

Suppose that the CAPM holds. All returns mentioned in the following are over the next year. The risk-free rate of return is 1%. The market portfolio has a Sharpe ratio of 0.25, and the standard deviation of the market portfolios rate of return is 20%. The rate of return on stocks in the company A has an expected value of 9% and a standard deviation of 40%.

a. Explain why the market can be in equilibrium even though the stocks of B and A have different standard deviations but the same expected returns.

b. Sketch diagrams showing the Security Market Line and the Capital Market Line. Indicate the location of the market portfolio, the stocks of B, and the stocks of A in both diagrams.