Is it possible to build a risk-free portfolio using risky assets?

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Expert Solution

Theoretically, it is possible. If you have 2 assets that only have diversifiable risk & no systematic risk (market risk) and their returns have a correlation coefficient of -1, their unsystematic risks would cancel out each other exactly. This can be generalized for any number of assets.

But practically there are no risky assets that have zero systematic risks. Any risky asset has both systematic as well as unsystematic risk. Systematic risk cannot be canceled out by diversifying with negatively correlated assets. So that part of risk always remains and thus it is practically not feasible to build a risk-free portfolio using risky assets.

Also, you can build a risk-free portfolio using risky assets in imperfect market situations where risk-free arbitrage opportunities exist. In such situations, it is possible to use derivatives (like futures and options) along with risky assets to have a portfolio that will provide risk-free arbitrage profits.

jeff jeffy answered 1 year ago

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