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(a) Suppose all the Capital Asset Pricing Model (CAPM) assumptions hold.  If you would like to earn a risk premium that is three times the market risk premium, what should you do?  

(b) Unlike part (a), suppose we cannot invest more than 200% in any risky assets.  Suppose all the other CAPM assumptions still hold.  If you would like to earn a risk premium that is the same as part (a), what should you do now?  Briefly explain using the graph below.  (No calculations necessary.)

CAL P2 CERERE Efficient Frontier p*

(c) Consider the portfolio you invest in part (b), should your portfolio contain mostly high-beta securities, or should your portfolio be very similar to the market portfolio?  Briefly explain.

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Answer #1

a) Based on the given situation, if we create a portfolio with investments of -200%, 300% in risk-free assets & market portfolio, the return for portfolio is Rp = -2*Rf + 3*Rf + 3*Market Risk Premium = Rf + 3*Market Risk premium. Therefore, to earn 3 times market premium, we shall take create a portfolio with -200% investment in Risk-free Asset & 300% investment in Market Portfolio

b) If the investment in risky assets is no greater than 200%, then to achieve 3 times market premium, we have to select a security with risk-premium of 1.5 times market premium. We can either find a single security with this premium or we can create this with combination of market portfolio & a higher risky security. To achieve the required return, Portfolio should have 200% investment in this chosen security & -100% investment in Risk-free asset.

c) This portfolio contains high-beta securities, as we have to select securities such that beta for the selected securities is 1.5.

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