please describe how adding a risk-free security to modern portfolio theory allows investors to do better...

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?

Expert Solution

Please describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier.

Modern portfolio theory is developed by Markowitz. MPT states how the investors who are risk averse construct a portfolio to achieve high rate of return at a given level of risk. Investors may construct an Efficient Frontier which contains optimal portfolios. Risk premium is the difference between the risk free rate of market portfolio and expected return from the portfolio. This premium is the result of taking extra risk. In a risk free security, the premium will be zero since there is no risk. When the portfolio constructed in Efficient Frontier is added with a risk-free security allows investors to to do better than the efficient frontier.

Explain how might the magnitude of the market risk premium impact people's desire to buy stocks?

Risk premium is the difference between the risk free rate of market portfolio and expected return from the portfolio. This premium is the result of taking extra risk. When the level of risk premium changes the behaviour of the investor changes. The market risk premium must be positive and it is assumed that the investors are risk averse. The investors those who have low level of risk aversion will be ready to take high risk and prefers to buy risky assets. But the investors who have high level of risk risk aversion will not be risk taking in nature and they always prefer less risky portfolio. Thus the magnitude of the market risk premium impact people's desire to buy stocks.

jeff jeffy answered 1 year ago

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