Question $3(17$ marks$)$

Steven is a financial planner at Morgan Investment Bank. He has just compiled data for the

analysis of two assets: Stock S and Portfolio M $($the "market portfolio"$).$ The performances of the

two assets under various states of the economy next year are shown in the table below.

$($a$)$ Compute the expected return for Stock $S.$

$(2$ marks$)$

$($b$)$ Based on the answer to $($a$),$ compute the standard deviation of return for Stock S and Portfolio

M$.$

$(5$ marks$)$

$($c$)$ Based on the results in $($a$)$ and $($b$),$ which asset $($Stock S or Portfolio M$)$ should Steven

recommends his clients to invest in$?$ Briefly explain.

$(2$ marks$)$

$($d$)$ Assume that the correlation coefficient between Stock $S$ and Portfolio M is $0\mathrm{.}4.$ If Steven

forms a portfolio that consists of $80\%$ of Stock S and $20\%$ of Portfolio M$,$ compute the

portfolio standard deviation of return.

$(3$ marks$)$

$($e$)$ Assume the risk$-$free return is $1\%$ and the portfolio formed in $($d$)$ has a beta value of $1\mathrm{.}4.$ Based

on CAPM, calculate the required rate of return of the two$-$asset portfolio formed in $($d$)$ and

explain whether you will invest in the portfolio.

$(5$ marks$)$