7 Consider the following two investment alternatives: First, a risky portfolio t

Question

7 Consider the following two investment alternatives: First, a risky portfolio that pays a 15% rate of return with a probability of 30% or a 4% rate of return with a probability of 70%. Second, a Treasury bill that pays 6%. The risk premium on the risky portfolio is A. 1% B.3% C. 13% D.9% 8. You invest $1,000 in a complete portfolio. The complete portfolio is composed of a risky asset with an expected rate of return of 1656 and a standard deviation of 20% and a Treasury bill with a rate of return of 6%.- _ of your complete portfolio should be invested in the risky portfolio if you want your complete portfolio to have an expected retum of 18%. A.120% B.90% C.40% D. 10% 9. What type of risk cannot be diversified away in a large portfolio? A. systematic risk B. firm-specific risk C. unsystematic risk D. unique risk

Explanation / Answer

Expected return on portfolio = 30% * 15% + 70% *4% = 7.30%

Risk premium = Expected return - Risk free rate = 1.30%

8) As we can see that the expected return of 18% is greater than what the risk portfolio offers us i.e. 16%. Hence we need to invest more than 100%

When weight of risk portfolio = 120%, we need to borrow 20% in risk free rate

Expected portfolio return = 120% *16% - 20% * 6% = 18%

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