Capital Market Line
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A portfolio that combines the risk-free asset and the market portfolio has an expected return of 25 percent and a standard deviation of 4 percent. The risk-free rate is 5 percent, and the expected return on the market portfolio is 20 percent. Assume the capital-asset-pricing model holds. What expected rate of return would a security earn if it had 0.5 correlation with the market portfolio and a standard deviation of 2 percent?
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Solution Summary
This post calculates the STD of the market portfolio using the Capital Market Line (CML).
Solution Preview
First of all, we need to calculate the STD of the market portfolio using the Capital Market Line (CML): The risk-free rate asset rate is 5% and a STD equal to zero; the portfolio has an expected return of 25% and a STD equal to 4%. These two points must lie on the Capital Market Line.
The slope of the Capital Market Line is:
Slope of CML = Increase in Expected Return / Increase in Standard Deviation
= (0.25- 0.05) / ...
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