Question

The capital asset pricing model (CAPM) suggests the investors first consider the market portfolio and then decide a portfolio that would require borrowing and lending to archive a desired level of risk and return trade off. For an investor who is willing to take more risk, this would mean that they borrow at the risk free rate and invest in the market portfolio and repeat the process every period. Suppose you are a long-term investor (saving for retirement) who is willing to hold a portfolio twice as risky as the market portfolio. How would you implement the suggestion of CAPM? What are the limitations? Explain.

Answer 1

As per CAPM model,

Required rate of return= Risk Free Rate+Beta*(market return-risk free rate)

Here, Beta is the relation between your portfolio and market portfolio. If, Beta 1, then it means your portfolio moves with the market portfolio.

If your Beta of your portfolio is 2, then it means if market increase or decrease by 1%, your portfolio increases or decreases by 2%.

Hence, here in this case, you are willing to hold a portfolio which has twice the risk, the market portfolio has. Hence, you need to form a portfolio with Beta=2

If, Market return=7%, and risk free rate=5%, then in this case your required rate of return=5%+2*(7%-5%)=9%

Here are the limitations of this assumptions:

We are ignoring the taxes and transaction costs.

Small investors are not divisible

Calculation on Beta depends on time of time and also varies as per methodology of calculations

Existence of completely risk free asset is not possible

Homogenous expectations of expected return is also possible. Etc