Question 2 [25 points]
For all parts of this question, assume that the CAPM holds (i.e. you can borrow and lend at the
risk–free rate, and there are no limitations to short–selling). The risk–free rate of return is 4%. The
market portfolio has expected rate of return of 10% and standard deviation of 12%.
1. Burger Inc. corporatio’s stock has an expected rate of return of 3.5% per year with a
volatility of 30%. Linda Belcher says, “No rational person would hold a risky asset
expected to return less than the riskless rate! It must be mispriced.”
Is Linda correct? Explain why.
2. Consider the following data on two stocks whose returns have a correlation of 0.6 with
each other:
Expected Return Standard Deviation
Walmart 8% 14%
Tesla 25% 45%
Bob Belcher owns $35,000 worth of Walmart stock, $15,000 worth of Tesla stock, and he has no
other investments.
a) Compute the expected rate of return (% per year), and volatility of Bob’s portfolio.
b) Suppose that Mr. Belcher says he cannot tolerate any more volatility than his portfolio has
right now. Given this risk tolerance, is he maximizing his expected return?
If he is, explain why? If he is not, explain how he should invest to maximize his expected
return without taking on more risk. (Hint: describe a specific trading and investment strategy).
