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Suppose that the risk%u2010free rate of interest is 5 percent the market risk premium is 6 percent and the

market standard deviation is 20 percent.

a. Plot the risk%u2010free asset and the market portfolio on coordinates with expected return on the

vertical axis and total risk (standard deviation) on the horizontal axis. Plot both assets on

coordinates with expected return on the axis and market risk (beta) on the horizontal axis and

sketch in the security market line.

b. Suppose the CAPM is correct and that an asset with a standard deviation of holding period

returns of 30 percent has an expected return of 12 percent. Plot the asset on both sets of

coordinates. How much of the total risk of the asset is market risk? What is the correlation

between the asset and the market portfolio.

c. Explain why another asset with a standard deviation of holding period returns of 30 percent

could have an expected return of 10 percent. What would the asset%u2019s risk characteristics need

to be?

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