Question

Suppose you borrow at the risk-free rate an amount equal to your initial wealth and invest in a portfolio with an expected return of 16% and a standard deviation of returns of 20%. The risk-free asset has an interest rate of 4%. Calculate the expected return on the resulting portfolio.

Answer 1

Answer: 28%

Step-by-step explanation:

If the initial wealth is given as 100 and since the initial wealth is thesame as the borrowed amount, this will be 100 as well. Then, the weight of the risk free asset will be:

= Amount invested in risk free / Initial wealth

= -100/100

= -1

Portfolio weight equals:

= 1 - (-1) = +2

Therefore, the expected return on the resulting portfolio will be:

= 2 × 16% + (-1 × 4)

= 32 - 4

= 28%