Suppose that many stocks are traded in the market and that it is possible to bor

Question

Suppose that many stocks are traded in the market and that it is possible to borrow at the risk-free rate, rƒ. The characteristics of two of the stocks are as follows:

Calculate the expected rate of return on this risk-free portfolio? (Hint: Can a particular stock portfolio be substituted for the risk-free asset?) (Round your answer to 2 decimal places.)

Could the equilibrium rƒ be greater than 5.60%?

Suppose that many stocks are traded in the market and that it is possible to borrow at the risk-free rate, rƒ. The characteristics of two of the stocks are as follows:

Explanation / Answer

A risk free portfolio can be created as both stocks are perfectly negatively correlated. Rate of return for this portfolio in equilibrium will always be risk free rate of return.

Lets set weight of A = wA

weight of B = wB=1-wA

Negative perfect correlation reduces portfolio standard deviation to

Standard deviation of portfolio = Abs[wA*STDEV of A - wB*STDEV of B]

0 = 20wA -80(1-wA)

100wA= 80

wA= 0.80

E(R) = 0.80*5% + 0.20*8% = 5.60%

No, Risk free rate also be 5.60% for equilibrium.

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