1. Supposed you invest $400,000 in government bonds and $ 600,000 in the market portfolio. what is the return on your portfolio if bonds yield 6 percent and the market risk premium is 8.6 percent? what does the return on this portfolio imply for the expected return on individual shares with betas of 0.6?
(The step of calculation must be shown)
2. Explain how forming a portfolio may result in reduction in risk. what is the necessary condition for this risk reduction to occur?
Here are your answers.
The fact that the market risk premium is 8.6% means that the expected return from investing in the market portfolio is 8.6% greater than the risk free rate (the yield from the government bonds). Since this rate is 6%, then we get that the expected return from the market portfolio is:
8.6 + 6 = 14.6%
Now, the formula for the expected return of a portfolio whose components are assets A and B is:
wA*rA + wB*rB
where wA and wB are the weights of assets A and B in the portfolio; and rA and rB are the expected returns from assets A and B. Let's say that the government bonds are asset A and the market ...
A paragraph and computation assist you with this. How forming a portfolio may result in reduction in risk is explained.