1.Suppose that the risk-free rate is 5% and the market portfolio has an expected
ID: 2633050 • Letter: 1
Question
1.Suppose that the risk-free rate is 5% and the market portfolio has an expected return of 13% with a volatility of 18%. Monsters Inc. has a 24% volatility and a correlation with the market of .60, while California Gold Mining has a 32% volatility and a correlation with the market of -.7. Assume the CAPM assumptions hold. Monsters' required return is closest to:
a.13.0% b.11.5% c.10.0% d.15.5%
2.Which of the following statements is FALSE?
Every investor should invest in the tangent portfolio independent of his or her taste for risk.
To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free investment.
If we increase the fraction invested in the efficient portfolio beyond 100% we are short selling the risk-free investment.
As we increase the fraction invested in the efficient portfolio, we increase our risk premium but not our risk proportionately.
aEvery investor should invest in the tangent portfolio independent of his or her taste for risk.
b.To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free investment.
c.If we increase the fraction invested in the efficient portfolio beyond 100% we are short selling the risk-free investment.
d.As we increase the fraction invested in the efficient portfolio, we increase our risk premium but not our risk proportionately.
Explanation / Answer
Acc to CAPM Ke= Rf+beta(Rm-Rf)
beta= correlation with the market x volatility of stock/ volatilityof market
beta= .6x24/18= .8
Ke= 5+.8(13-5)
Ke= 11.4%
Monsters' required return is closest to: (b) 11.5%
the correct answer is (c) If we increase the fraction invested in the efficient portfolio beyond 100% we are short selling the risk-free investment.
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