Question 5 (25 marks / Risk, Return and CAPM) (Each of the following parts is independent.) (a) According to the Capital Asset Pricing theory, what return would be required by an investor whose portfolio is made up of 40% of the market portfolio (m) and 60% of Treasury bills (i.e. risk-free asset)? Assume the risk-free rate is 3% and the market risk premium is 7%? (6 marks)

(b) You are considering investing in the following two stocks. The risk-free rate is 7 percent and the market risk premium is 8 percent.

Stock ,Price Today , Expected Price in 1 year, Expected Dividend in 1 year, Beta X $20 $22 $2.00 1.0 Y $30 $32 $1.78 0.9

i) Compute the expected and required return (using CAPM) on each stock. (8 marks) ii) Which asset is worth investing? Support your answer with calculations. (2 marks)

(c) Which pair of stocks used to form a 2-asset portfolio would have the greatest diversification effect for the portfolio? Briefly explain. Correlation Stocks A & B -0.66 Stocks A & C -0.42 Stocks A & D 0 Stocks A & E 0.75 (d) Explain the terms systematic risk and unsystematic risk and their importance in determining investment return. (5 marks)