Stock A has expected return of 15% and standard deviation (s.d.) 20%. Stock B has expected return 20% and s.d. 15%. The two stocks have a correlation coefficient of 0.5.

a. Note that Stock A has greater risk (s.d.) that Stock B, but a lower expected return. Explain how is this possible in a world where returns on assets are as predicted by the CAPM. b. Determine the expected return and the s.d. of portfolio P1, composed by investing 30% in stock A and 70% in stock B.

c. Consider stock C that has expected return 15% and s.d. 15%. Stock C is uncorrelated with either stock A and stock B. Determine the expected return and s.d. of portfolio P2 made by investing 50% in stock C and 50% in portfolio P1.

d. The beta of stock A is 1 and the beta of stock B is 1.5. What is the risk premium on the market portfolio, if the CAPM holds ?

e. Stock D has a beta of 1.2 and expected return 18%. Is this stock overvalued, if the CAPM holds?