Question

Assume all investors want to hold a portfolio that, for a given level of volatility, has the maximum possible expected return. Explain why, when a risk-free asset exists, all investors will choose to hold the same portfolio of risky stocks.

(Select the best choice below.)

A. All investors will do the same thing long dash—that is, they will minimize their volatilities long dash—so they will all hold the same portfolio.

B. When a risk-free asset exists, it provides a safe investment opportunity. Given this safe investment opportunity, investors who maximize their expected returns for a given level of volatility will pick the same expected return and, hence, the same portfolio.

C. All investors will do the same thing long dash—that is, they will maximize their expected returns long dash—sothey will all hold the same portfolio.

D.Investors who want to maximize their expected return for a given level of volatility will pick portfolios that maximize their Sharpe ratio. The set of portfolios that does this is a combination of a risk-free asset and a single portfolio of the risky assets long dash—thetangential portfolio.

Answer 1

Risk free return gives minimum return will zero risk as measured by volatility.

As return increases by adding risky assets in the portfolio, the risk or volatility also increases.

All investors will like to have maximum return with minimum volatility or risk.

This can be achieved by maximizing the Sharp ratio of the portfolio. Sharp ratio can be defined as the return earned in excess of risk free rate divided by the volatility or standard deviation of the portfolio.

Sharp ratio=(Portfolio return- Risk free return)/Standard deviation.

Investors will need to consider both--return and volatility. Hence A, B and C are incorrect.

D. Investors who want to maximize their expected return for a given level of volatility will pick portfolios that maximize their Sharpe ratio. The set of portfolios that does this is a combination of a risk-free asset and a single portfolio of the risky assets long dash—thetangential portfolio.