Question 1

Assume that CAPM is a good representation of the risk-return relationship. You are holding a portfolio of stocks. The portfolio's standard deviation is 40% and its correlation with "M" is 0.8. The risk free rate is 2.5%, the expected market return is 12%, and the standard deviation of the market return is 17.6%.

1.What is the expected return on your portfolio?

2.Is this portfolio efficient? How can you tell?

3.If this portfolio is not efficient, how much risk reduction could you achieve, at no sacrifice in expected return, by making your portfolio an efficient one?

4.Now suppose that you are comfortable with the overall risk of your current portfolio, but want to improve your return by making your portfolio efficient. What would be the return on the efficient portfolio with the same overall risk as your current portfolio?

Question 2

Consider a put option on a non-dividend-paying stock when the stock price is $30, the exercise price is $29, the risk-free rate is 5%, the volatility is 25% per annum, and the time to maturity is four months.

a.Use a 2-period binomial model to price this same option.

b.Use Black-Scholes formula to value this option

c.How much the European call option on this stock with the same strike (E) and time to maturity (T) will cost?

d.How much the American call with the same E and T will cost?