You are evaluating various investment opportunities currently available and you

Question

You are evaluating various investment opportunities currently available and you have calculated expected returns and standard deviations for five different well-diversified portfolios of risky assets: A) For each portfolio, calculate the risk premium per unit of risk that you expect to receive (E( R ) - RFR/o. Assume that the risk-free rate is 3.0% b) using your computations in Part a,explain which of these five portfolios is most likely to be the market portfolio. Use your calculations to draw the capital market line (CMI). c) If you are only willing to make an investment with o=7.0%, is it possible for you to earn a return of 7.0%? d) What is the minimum level of risk that would be necessary for an investment to earn 7.0%? What is the composition of the portfolio along the CML that will generate that expected return? e) Suppose you are now willing to make an investment with o=18.2% What would be the investment proportions in the riskless asset and the market portfolio for this portfolio? What is the expected return for this portfolio?

Portfolio Expected Return Standard deviation Q 7.80% 10.50% R 10 14 S 4.6 5 T 11.7 18.5 U 6.2 7.5

Explanation / Answer

a)

Given that Risk free rate = 3%

b)

As we can see that portfolio "R" has highest risk premium for per unit risk therefore portfolio R is the market portfolio.

With 0.5000 risk premium expected return are:

c)

Investment with O=7%

Return = (3% + 7%) * 0.500 = 6.5%

Hence we can see that its not possible to earn a return of 7%.

d)

Minimum level of risk for 7% return = (7% - 3%) * 0.500 = 8%

e)

We have,

= 18.2%

Return = 3% +(18.2*0.500) = 12.100%

Therefore,

Proportion to be invested in riskless protfolio =

(10% - 12.100%) / ( 10% - 3%) = -30%

Proportion to be invested in rmarket protfolio =

(1- (-30%)) = 130%

Portolio Risk Premium per unit of risk Q 0.4571 R 0.5000 S 0.3200 T 0.4703 U 0.4267

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