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Homework 3 BF722, Spring 2012

April 18, 2012
Instructions: Work in a group of 1 – 4 people. Each group hands in one copy of their answers. Be brief and to the point, but be sure to fully explain your logic. Due Date: May 3, 2012

Problem Sets 1. You are going to invest for one period. You can invest in two risky stocks: Krispy Kreme (KK) and General Motors (GM). The sky opens and the following is written: State Good Economy Bad Economy Probability 0.50 0.50 rkk 20% 0% rgm 10% 5%

(a) Compute the expected return of KK and GM (b) Compute covariance between KK and GM. 2. You are going to invest for one period. You can invest in two risky stocks: BP and WWE. The sky opens and the following is written: State Good Economy Bad Economy Probability 0.60 0.40 rbp 30% -20% rwwe 0% 15%

(a) Compute the expected return and standard deviation of BP, and the expected return and standard deviation of WWE. (b) Suppose you have $20,000 and you invest $12,000 in BP and $8,000 in WWE. What is the expected return and standard deviation of your portfolio? 3. The expected return of Nike is 5% with a standard deviation of 9%. The expected return of Walmart is 13% with a standard deviation of 20%. The correlation between the two stocks is 0.35. The riskfree rate is 3%. Suppose you invest 30% of your money in Nike and 70% in Walmart. What is the expected return and standard deviation of your portfolio? 1

4. The market portfolio has a beta of (a) 0. (b) 1. (c) -1. (d) 0.5. (e) none of the above 5. The risk-free rate and the expected market rate of return are 0.06 and 0.12, respectively. According to the capital asset pricing model (CAPM), the expected rate of return on security X with a beta of 1.2 is equal to (a) 0.06. (b) 0.144. (c) 0.12. (d) 0.132 (e) 0.18 6. Which statement is true regarding the Capital Market Line (CML)? (a) The CML is the line from the risk-free rate through the market portfolio. (b) The CML is the best attainable capital allocation line. (c) The CML is...
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