Question 4(14 marks)

1. What is the risk premium of a zero-beta stock?Does this mean you can lower the volatility of a portfolio without changing the expected return by substituting out any zero-beta stock in a portfolio and replacing it with the risk-free asset? (4 marks)

2. Assume all investors want to hold a portfolio that, for a given level of volatility, has the maximum possible expected return. Explain why, when a risk-free asset exists, all investors will choose to hold the same portfolio of risky stocks. (3 marks)

3. Consider the following two independent projects:

Project	Year 0 Cash Flow	Year 1 Cash Flow	Year 2 Cash Flow	Year 3 Cash Flow	Year 4 Cash Flow	Discount Rate
A	90	40	-20	60	-20	16%
B	-80	40	40	30	30	16%

Without doing any calculation, explain why the above two projects canor cannotbe evaluated using the IRR Rule. (3 marks)

4. Suppose ABC and XYZ have volatilities of 25% and 50% respectively and they are perfectly negatively correlated. What portfolio of these two stocks has a zero risk? Show all your calculations. (4 marks)