Hello,

can you pls explain the question 1 in an attachment. Having a hard time computing the portfolio variance. Thanks!

1 Problems M-V Eciency and CAPM 1. A portfolio consists of the following three stocks, whose performance depends on the economic environment. Stock Investments ($) Good Bad 1 500 +13% 20% 2 1, 250 +6% +3% 3 250 7% +2% Assuming that the good economic environment is twice as likely as the bad one, compute the expected return and variance of the portfolio. What if $1, 000 of stock 4, which has mean return of 4%, a variance of 0.02, and is uncorrelated with the preceding portfolio, is added to the portfolio? How will this change the expected return and variance of the total investment? 2. In the CAPM setting, it is argued that only a fraction of the total risk of a particular asset is priced. Use the CML and SML to prove this assertion. 3. Derive the CAPM relationship rj = rf + ( rM rf ) 1 jM . 2 M