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    Capital-asset pricing model

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    A portfolio that combines the risk-free asset and the market portfolio has an expected return of 22 percent and a standard deviation of 5 percent. The risk-free rate is 4.9 percent, and the expected return on the market portfolio is 19 percent. Assume the capital-asset pricing model holds.

    What expected rate of return would a security earn if it had a 0.6 correlation with the market portfolio and a standard deviation of 3 percent?

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    Solution Preview

    A portfolio that combines the risk-free asset and the market portfolio has an expected return of 22 percent and a standard deviation of 5 percent. The risk-free rate is 4.9 percent, and the expected return on the market portfolio is 19 percent. Assume the capital-asset pricing model holds.

    What expected rate of return would a security earn if it had a 0.6 correlation with the market portfolio and a standard deviation of 3 percent?

    Any portfolio that is a combination of risk free asset and the market portfolio is an efficient portfolio.
    It would therefore lie on the Capital Market Line (CML).
    The equation for CML is:
    E(r) = r f + {(rM-rf)/ sM} s ...

    Solution Summary

    The solution calculates the expected rate of return on a security if it has a 0.6 correlation with the market portfolio and a standard deviation of 3 percent. The concepts of Capital market line and Security market line (SML) are employed.

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