CAPM Solved Questions

Top Gun is looking to invest in risk assets. Young and dynamic, Top Gun is willing to take a higher risk for a higher return. His portfolio manager has two choices ahead. First, invest in an efficient frontier based on the risk profile and investment horizon for investment. Second, investment in Capital Market Line using separate theorem mixing assets between risky asset (market portfolio) and risk-free assets. (Top Gun is a metaphor and unisex, used for either genders).

a. Which option should the portfolio manager chose and why?

b. Top Gun wants to leverage his exposure in risky assets based on the suggestion of his portfolio manager. He borrows 50% of his original investment sum in risk free assets at 4%. The market premium for the market portfolio is 8%. What’s is the expected return of the portfolio?

c. What happens when you use leverage? If the borrowing is increased to 80% of the initial investment amount, will the expected return and standard deviation increase or decrease?

Answers

a. Which option should the portfolio manager chose and why?
All portfolios on the CML line i.e. mix of risk-free rate and market portfolio are superior to any portfolio on the efficient frontier. The manager should seek portfolios on the CML line depending on investors risk profile and investment horizon.

b. Top Gun wants to leverage his exposure in risky assets based on the suggestion of his portfolio manager. He borrows 50% of his original investment sum in risk free assets at 4%. The market premium for the market portfolio is 8%. What’s is the expected return of the portfolio?
Ans. 16%

c. What happens when you use leverage? If the borrowing is increased to 80% of the initial investment amount, will the expected return and standard deviation increase or decrease?
Ans. The expected return and standard deviation will increase.