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10. (20 points) Suppose that you're given the following information of rates of return for
the stock market as assessed by your financial analyst in mutual fund. Answer the
following questions:
a) What are the means, standard deviations for each fund? Why does the "mean" of
the rate of return represent the expectation on the risky asset?
b) What are the co-variances for these funds? Are these funds mutually
"diversifiable"? Why or why not?
c) Explain the assumption(s) and reason(s) why the expected rate of return of
investor can be represented by the expected value of the rate of return.
d) Suppose that Fund A represents the Market Portfolio. Let the risk-free rate be 2%,
what are the required rates of return for Fund B, and Fund C?
States of the
Probability
Fund A
Fund B
Fund C
world
Boom
1/2
10%
36%
10%
Recovery
1/4
24%
12%
10%
Recession
1/4
-4%
-12%
2%

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