Financial Economics Problem

Problem 1 (10 points) Suppose the Capital Asset Pricing Model (CAPM) is valid in a simple market. Use CAPM to explain and answer following questions. Note: There is no relationship between each situation. (a) Why risk-free portfolio has 3 = 0? Why AM is 1? Can these portfolios exist in the market? (Hint: Security market line) If yes, compute risk premium on portfolio A. Portfolio Expected return Beta Risk-free 6% 0 Market 15% 1 A 12% 1.5 (b) Can these portfolios exist in the market? (Hint: Capital market line) If yes, com- pute risk premium on portfolio B. Portfolio Expected return Standard deviation Risk-free 6% 0 Market 15% 12% B 12% 10%