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Market Model

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Assume that the following market model adequately describes the return-generating behavior of risky assets.

Rit = ai + ßiRmt + єit

Where Rit = the return for the ith asset at time t

And Rmt = the return on a portfolio containing all risky assets in some proportion, at time t

Rmt and єit are statistically independent

Suppose the following data are true.

Asset Bi E(Ri) Var(Ei)
A 0.7 8.41% 1.00%
B 1.2 12.06 1.44
C 1.5 13.95 2.25
Var(Rmt) = 1.21%

a. Calculate the standard deviation of returns for each asset.
B. Assume short selling is allowed.
i. Calculate the variance of return of three portfolios containing an infintite number of asset types A,B or C respectively.
ii. Assume Rf = 3.3% and Rm = 10.6%. Which asset will not be held by rational investors?
iii. What equilibrium state will emerge such that no arbitrage opportunities exists? Why?

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Solution Summary

The solution explains how to calculate the standard deviation of returs, the variance and the equilibrium stage