Suppose that the relevant equilibrium model is CAPM and the

risk-free rate is 4%. Total return variance of a stock return could be decomposed into systematic (i.e. market risk) variance and firm specific variance. Consider the following assets:

Asset Expected Return Total Return Variance. Firm Specific Variance

A 10.00% 0.3844 0.2548

B 9.00% 0.5476 0.4576

C 14.00% 0.3600 0.0000

D 8.50% 1.4225 0.8600

1. A risk-averse investor with a well-diversified portfolio is considering adding asset A or asset B to his/her portfolio. S/he would like to choose the one with lower systematic risk. Which asset would you recommend? Show your calculations.

2. Suppose that asset C has a beta of 1 and is correctly priced. Is asset D correctly priced? If not, overpriced, or underpriced? Show your calculation.