Question

in your own words ,explain how to achieve investor equilibrium combining a risk free asset with the market portfolio .Make sure to include all of the relevant components in your explanation

Answer 1

The risk-free rate is a big element in capital market theory. The US treasury bill is a common instrument used as a risk-free rate security. By combining risky assets with risk free securities in a portfolio, the overall risk and return will appeal to different investors having varying appetite for risk. Risk averse investors will choose to buy more risk free assets while, risk aggressive investors would include more risky assets in their portfolio.

Adding risk-free makes the expected return entirely certain. The line of possible portfolio combinations given the portfolio risk and return of a portfolio of risky assets and risk-free assets is referred to as the Capital Allocation Line. The best capital allocation line is the one that offers the preferred portfolios in terms of risk and return. Capital Market Line is the line which makes up the allocation between the risk-free asset and a risky portfolio for an investor. Market equilibrium is achieved when the tangency portfolio is the market portfolio in the capital market line.

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