Problem .

Assume that the market consists of two stocks, Aggressive (A) and Defensive (D), and that the CAPM is true. A has an expected return of 20% and a standard deviation of 35%. D has an expected return of 6% and a standard deviation of 10%. The correlation between the stocks is -0.7 (note: negative correlation). The return on the risk-free assets is 5%. Investors may borrow or lend at the risk-free rate.

Please answer the questions below:

(a) Compute the expected return, the variance, and the Sharpe Ratio of a portfolio that consists of 30% in A and 70% in D

(b) The market value of stock A is $ 13.130 and the market value of stock D is $ 36.870. Report the market value of the market portfolio, and the weights in the portfolio with the highest Sharpe Ratio

(c) Report the CAPM-beta of stock A, and the expected return on stock A according to the CAPM

(d) The average investor holds the market portfolio. Compute the risk-aversion coefficient of the average investor (hint: y = E(rp)rf A2(rp) , where y is the optimal share in the risky asset). What is likely to happen with the risk premium of the market portfolio if the average investor becomes more risk averse?