Question

Please consider all that we have learned thus far regarding the impact of diversification, risk-free securities,...

Please consider all that we have learned thus far regarding the impact of diversification, risk-free securities, and market premiums. With that in mind, Please describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier. Additionally, explain how might the magnitude of the market risk premium impact people's desire to buy stocks?

Homework Answers

Answer #1

what do the risk-free rate and the optimal risky portfolio(efficient Frontier) create?

They create a portfolio with the maximum utility.

1. Modern portfolio theory assumes that investors are rational.
2. They want to maximize the utility of their portfolio.
3. According to modern portfolio theory utility is a positive function of return and negative function of risk.
4. To calculate portfolio with maximum utility, we calculate the coefficient of variation.
5. Coefficient of variation is standard deviation divided by the return of the portfolio.
6. Lower the coefficient of variation, the better, the lower the unit of risk per unit of return.
7. The portfolio with a lower coefficient of variation in the pool of portfolio- lies on efficient Frontier.
8. So a portfolio on efficient Frontier gives the lowest amount of risk per unit of return.
9. That's why we invest in the portfolio on efficient Frontier rather than portfolio below the Efficient Frontier (inefficient portfolio/all other possible portfolios).
10. By adding a risk-free asset to the optimal risk portfolio - the overall return increase keeping the Sharpe ratio intact.

How?
11. This is done by shorting the risk-free asset and investing the proceeds in the optimal portfolio. As the portfolio has a higher return then compared to the risk-free asset.
Thus increasing the overall return.

Thus investing in such a way by improving utility maximization.


Market risk premium decides the overall return on the equity.

As per the Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)B

Re= required rate of return/return on equity.
Rf= Risk-free rate.
Rm =Market Risk Premium.
B = Beta, systematic risk.

So from the equations, it becomes clear that as market risk premium increases/decreases so does the return on equity.

As the return on equity increase/decreases so does the willing to buy stock increases/decreases.

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
"Diversification" Please respond to the following: Justify whether adding securities to the portfolio reduces the portfolio...
"Diversification" Please respond to the following: Justify whether adding securities to the portfolio reduces the portfolio risk as measured by the standard deviation and the benefits of diversification, using historical data to examine the effects including stocks and bonds on a portfolio. Provide support for your justification. An investor ponders various allocations to the optimal risky portfolio and risk-free T-bills to construct his complete portfolio. Predict two ways that systematic risk could affect the investor’s plan. Support your prediction with...
QUESTION 21 One implication of the tradeoff theories of capital structure decision is that firms that...
QUESTION 21 One implication of the tradeoff theories of capital structure decision is that firms that are likely to pay taxes at high rates should carry more debt than firms in lower tax brackets. True False 1.00000 points    QUESTION 22 One implication of the tradeoff theories of capital structure decision is that risky firms, as measures by the variability of asset returns, ought to borrow more, other things equal. True False 1.00000 points    QUESTION 23 The pecking order...
John and Marsha on Portfolio Selection The scene: John and Marsha hold hands in a cozy...
John and Marsha on Portfolio Selection The scene: John and Marsha hold hands in a cozy French restaurant in downtown Manhattan, several years before the mini-case in Chapter 9. Marsha is a futures-market trader. John manages a $125 million common-stock portfolio for a large pension fund. They have just ordered tournedos financiere for the main course and flan financiere for dessert. John reads the financial pages of The Wall Street Journal by candlelight. John: Wow! Potato futures hit their daily...
read Seasons of Love chapter:measuring a child's life after suicide. please answer the questions : reflect...
read Seasons of Love chapter:measuring a child's life after suicide. please answer the questions : reflect on what happens to the families when there is a suicide in the family, based on the Seasons of Love chapter...how should people be told? What details are best left unshared? below is the story These theories may have a certain face-validity, but they often neglect environmental or contextual factors that are innate to answering the question of “why” a person might engage in...
What tools could AA leaders have used to increase their awareness of internal and external issues?...
What tools could AA leaders have used to increase their awareness of internal and external issues? ???ALASKA AIRLINES: NAVIGATING CHANGE In the autumn of 2007, Alaska Airlines executives adjourned at the end of a long and stressful day in the midst of a multi-day strategic planning session. Most headed outside to relax, unwind and enjoy a bonfire on the shore of Semiahmoo Spit, outside the meeting venue in Blaine, a seaport town in northwest Washington state. Meanwhile, several members of...
Delta airlines case study Global strategy. Describe the current global strategy and provide evidence about how...
Delta airlines case study Global strategy. Describe the current global strategy and provide evidence about how the firms resources incompetencies support the given pressures regarding costs and local responsiveness. Describe entry modes have they usually used, and whether they are appropriate for the given strategy. Any key issues in their global strategy? casestudy: Atlanta, June 17, 2014. Sea of Delta employees and their families swarmed between food trucks, amusement park booths, and entertainment venues that were scattered throughout what would...