Suppose that an investor is faced with two investments, Aberdeen Safe Haven plc and ScotRisk plc. They have the following patterns of historic yearly returns:

ASHplc: r1 =10 A =20 SR plc: r2 = 5 2 = 10

The correlation coefficient between the returns of the stocks has been estimated as AS = 0.1.

a) Suppose that the investor has 1,000. The securities in ASH and SR are divisible in units of 10 and transaction costs are trivial. Derive the portfolio mean annual return and the variance for xA = 0.2, 0.4, 0.6, 0.8, 1,0, where xA is the fraction of the portfolio held in ASH.

(40 marks)

b) Draw a figure and plot in the return and risk of the portfolios available for the investor.

Are any portfolios dominated by others? Explain.

(30 marks)

c) Based on your answer to b), and assuming that rf = 3, explain and develop how the CAPM model relates risk measures to required returns on investments such as these. Show, diagrammatically, the Capital and Security Market Lines.

(30 marks) (Total: 100 marks)