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    Portfolio: Capital-Asset-Pricing Model (CAPM)

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    A portfolio that combines the risk-free asset and the market portfolio has an expected return of 22% and a standard deviation of 5%. The risk-free rate is 4.9% and the expected return on the market portfolio is 19%. Assume the capital-asset-pricing model holds. What expected rate of return would a security earn if it had a 0.6 correlation with the market portfolio and a standard deviation of 3%?

    a. Without showing mathematical calculations, explain in writing how you would solve the problem.
    b. What financial concept or principle is the problem asking you to solve?
    c. In the context of the problem scenario, what are some business decisions that a manager would be able to make after solving the problem?
    d. Is there any additional information missing from the problem that would enhance the decision-making process?

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    Solution Preview

    Please view the attachment for proper formatting.
    a. Without showing mathematical calculations, explain in writing how you would solve the problem.
    Any portfolio that is a combination of risk free asset and the market portfolio is an efficient portfolio.
    It would therefore lie on the Capital Market Line (CML).
    The equation for CML is:
    E(r) = r f + {(rM-rf)/ sM} s
    E(r) = Expected return on portfolio
    rM =Expected Value of market rate of return
    sM =Standard deviation of market return
    rf = risk free rate of return
    s= standard deviation of portfolio

    Given the following in the first case
    E(r) = 22%
    rM = 19%
    rf = 4.90%
    s= 5%
    The missing data is ...

    Solution Summary

    This solution explains how a problem on the capital-asset-pricing model (CAPM) can be solved. Additionally, an Excel file is attached which contains the full solution with proper formatting.