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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

The risk-free rate is 6% and the market portfolio has expected return 12% and standard deviation 15%. According to the capital market line, what is the expected return of an efficient portfolio with standard deviation 20%?

The expected return is 14%. The CML slope is the market risk premium divided by market standard deviation, 6%/15% = 0.4. Adding 0.4 times 20% = 8% to the 6% risk-free rate gives 14%.

  1. A14.0%
  2. B15.0%
  3. C16.0%Correct
  4. D17.0%
  5. 18.0%

Explanation

The slope of the CML is (12%-6%)/15% = 0.4. The expected return is 6% + 0.4 × 20% = 14%. Check: that is 20/15 = 1.333 times the market risk premium of 6% = 8%, plus 6% gives 14%.

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