We have a nancial market with many stocks and a risk-free asset. Assume that the

expected return and risk of the market portfolio are M = 7% and M = 10%, and the risk-free

return is R = 4%.

a) (3 pts) Consider two stocks S1 and S2. Your investment banker friend tells you that he has

an inside information according to which 1 = 5% and 2 = 10%. From historical data you

estimate the beta factors of the two stocks to be 1 = 0:7 and 2 = 1:4. If you believe in your

friend's information more than you believe in CAPM, which of the stocks should you buy and

which should you sell? (Hint: what is the expected return of S1 and S2 if we calculate using

CAPM?)

b) (2 pts) Let V and P be two portfolios. Assuming that (V ; V ) = (15%; 8:5%) and (P ; P ) =

(4%; 5%), for each of the portfolios V and P determine if it lies on the Capital Market Line.