Question

Assume that security returns are generated by the single-index model,

R_i = α_i + β_iR_M + e_i

where R_i is the excess return for security i and R_M is the market’s excess return. The risk-free rate is 4%. Suppose also that there are three securities A, B, and C, characterized by the following data:

Security	βi	E(Ri)	σ(ei)
A	1.3	14%	27%
B	1.5	16	13
C	1.7	18	22

a. If σ_M = 22%, calculate the variance of returns of securities A, B, and C. (Do not round intermediate calculations. Round your answers to the nearest whole number.)

	Variance
Security A
Security B
Security C

b. Now assume that there are an infinite number of assets with return characteristics identical to those of A, B, and C, respectively. If one forms a well-diversified portfolio of type A securities, what will be the mean and variance of the portfolio’s excess returns? What about portfolios composed only of type B or C stocks? (Enter the variance answers as a percent squared and mean as a percentage. Do not round intermediate calculations. Round your answers to the nearest whole number.)

	Mean	Variance
Security A	%
Security B	%
Security C	%

Answer 1

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