FIN 435 – Problem set

Questions

1. Explain why the set of points between the risk-free asset and a portfolio on the Markowitz
efficient frontier is a straight line.

2. Draw and explain why the line from the RF that is tangent to the efficient frontier defines
the dominant set of portfolio possibilities.

3. The capital asset pricing model (CAPM) contends that there is systematic and unsystematic
risk for an individual security. Which is the relevant risk variable and why is it relevant? Why
is the other risk variable not relevant?

4. How does the SML differ from the CML?

Problems

5. You expect an RF of 10 percent and the market return (RM) of 14 percent. Compute the
expected (required) return for the following stocks, and plot them on an SML graph.

Stock Beta E(R)

U 0.85
N 1.25
D – 0.20

6. You ask a stockbroker what the firm’s research department expects for the three stocks in
Problem 5. The broker responds with the following information:

Stock Current price Expected price Expected dividend

U 22 24 0.75
N 48 51 2.00
D 37 40 1.25

Plot your estimated returns on the graph from Problem 5 and indicate what actions you would
take with regard to these stocks. Discuss your decisions.