Explanation:

The correct answer is B (13.2%).

1. Calculate the beta (β) of the security: The beta is calculated using the formula:

   $$\beta = \frac{\rho_{i,m} \times \sigma_i}{\sigma_m}$$

   Where:

   • $\rho_{i,m}$ is the correlation between the security and the market (0.8).
   • $\sigma_i$ is the standard deviation of the security (35%).
   • $\sigma_m$ is the standard deviation of the market portfolio (20%).

   Substituting the values:

   $$\beta = \frac{0.8 \times 35\%}{20\%} = 1.4$$

2. Calculate the expected return using CAPM: The CAPM formula is:

   $$E(R_i) = R_f + \beta \times [E(R_m) - R_f]$$

   Where:

   • $R_f$ is the risk-free rate (2%).
   • $E(R_m)$ is the expected return of the market (10%).

   Substituting the values:

   $$E(R_i) = 2\% + 1.4 \times (10\% - 2\%) = 2\% + 1.4 \times 8\% = 2\% + 11.2\% = 13.2\%$$

Why not A or C?

• Option A (5.7%) is incorrect because it miscalculates the beta by reversing the standard deviations of the security and the market portfolio.
• Option C (16.0%) is incorrect because it excludes the risk-free rate from the calculation of the market risk premium.