In: Finance
Assume that security returns are generated by the single-index model,
Ri = αi +
βiRM + ei
where Ri is the excess return for security
i and RM is the market’s excess
return. The risk-free rate is 3%. Suppose also that there are three
securities A, B, and C, characterized by
the following data:
Security | βi | E(Ri) | σ(ei) | ||
A | 1.4 | 14 | % | 23 | % |
B | 1.6 | 16 | 14 | ||
C | 1.8 | 18 | 17 | ||
a. If σM = 22%, calculate the variance of returns of securities A, B, and C.
b. Now assume that there are an infinite number of assets with return characteristics identical to those of A, B, and C, respectively. What will be the mean and variance of excess returns for securities A, B, and C?