Question 5-1 (Fundamental) 40 marks An investor wishes to invest in two shares that have the following risk/return profiles: Economic State Probability Expected return Expected return Share A Share B 0,3 2% 15% W N H 0,5 10% 22% 0,2 12% - 2% The following information is available: 1 The risk-free rate is 3%. 2 The market return is 12%. 3 The standard deviation of expected market returns is 6%. 4 The covariance of Share A returns with those of the market is 25,2. 5 The covariance of Share B returns with those of the market is 39,6. Required: (a) Calculate the expected returns for Shares A and B; the covariance of returns between the two shares, and the correlation between Share A and Share B. (8 marks) (b) Determine the expected return of a portfolio consisting of 40% Share A and 60% Share B together with the risk of the portfolio and discuss whether you would advise the investor to purchase the port- folio. (5 marks) (c) Calculate the required return for Shares A and B according to the Capital Asset Pricing Model, and discuss whether you would advise the investor to invest in either Share A or Share B. (8 marks) (d) Illustrate your answer to (c) above by showing the position of Shares A and B in relation to the Securities Market Line. (4 marks) (e) Briefly explain why the CAPM measures return versus beta, rather than standard deviation. (8 marks) (f) Briefly describe the limitations of using the CAPM for capital budgeting decisions. (7 marks)