1. Consider the following information about the characteristics of two securities, A and B; the market portfolio, M; and the risk-free rate of return:

Security           r(R_i, R_M)         s(R_i)

A                     0.5                   0.4

B                     0.7                   0.8

E(R_M) = 0.25               s(R_M) = 0.75               R_F = 0.06

r(R_i, R_M) denotes the correlation between the returns on security i and the returns on the market portfolio; s(R_i) denotes the standard deviation of the returns on security i, E(R_M) denotes the expected return on the market portfolio; s(R_M) denotes the standard deviation of the returns on the market portfolio; and R_F denotes the risk-free rate of return.

(a) Calculate b_i (beta) for each of the following:

            (i) Security A

            (ii) Security B

(b) According to the Capital Asset Pricing Model (CAPM), what are the expected returns for securities A and B?

(c) Write down expressions for the characteristic lines for securities A and B. Draw sketches of the characteristic lines for securities A and B. Explain briefly how you would interpret the characteristic lines.

2. "In many respects, the APT is considered a general case of the CAPM". With reference to the limitations of the CAPM, discuss this statement.

3. With reference to specific factors, discuss how multifactor models perform in explaining individual security returns.