Question

1. Assume that you regularly invest in stocks. Explain (using intuition instead of math) how your portfolio of stocks would be affected in response to a higher risk-free rate according to the CAPM.

Explain how your portfolio of stocks might be impacted during the economic growth.

Answer 1

Since we don't have to use math, we try to think of our required return from our investment in terms of what other options are available to us and what advantage do we get by investing in those. So, if the risk-free rate is higher that means that even the riskless asset has become slightly risky as compared to before. Hence, this implies that since even a riskless asset has become more risky, stocks will also become more risky. Hence, because of more risk our average return expected from the stock will increase and fewer people will invest in stocks because those people whose risk-appetite was limited wouldn't be investing in stocks now or will be investing less in stocks now. Talking about our portfolio, we will have a specific amount of risk in mind which we can take. Hence, in our portfolio, the percentage of riskless assets and assets having less risk (like popular stocks) will increase.

During periods of economic growth, the risk-free rate comes down. Hence, this situation will be the reverse of what we saw in the previous situation. We will have more and more risky assets in our portfolio because at the same amount of risk than before, we are now getting a higher return. The percentage of riskless assets will decrease in our portfolio.