1A) You are going to add one of the following three projects to your already wel

Question

1A) You are going to add one of the following three projects to your already well diversified portfolio.

PROJECT 1 PROJECT 2
Standard Standard
Probability Return Deviation Beta Probability Return Deviation
Beta
50% Chance 22% 12% 1.2 30% Chance 36% 19.5% 0.8
50% Chance -4% 40% Chance 10.5%
30% Chance -20%
PROJECT 3
Standard
Probability Return Deviation Beta
10% Chance 28% 12% 2.0
70% Chance 18%
20% Chance -8%
Assume the risk-free rate of return is 2% and the market risk premium is 8%. If
you are a risk averse investor, which project should you choose?
a. Either Project 2 or Project 3 because the higher expected return on
project 3 offsets its higher risk.
b. Project 2
c. Project 1
d. Project 3


1B The beta of ABC Co. stock is the slope of:
a. The arbitrage pricing line.
b. The security market line.
c. The characteristic line for a plot of returns on the S&P 500 versus
returns on short-term Treasury bills.
d. The characteristic line for a plot of ABC Co. returns against the returns
of the market portfolio for the same period.

Explanation / Answer

1A) The project-1 is the right option because it has the highest return with low standard devation and low beta.

1B) The beta of ABC Co. stock is the slope of the security market line. SML graphs are obtained from the CAPM formula. The slope of the SML determines the market risk premium.

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