Financial Risk Manager Part 1
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A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky asset with an expected return of 14% and a standard deviation of 22%, and asset B is a risk-free asset with an expected return of 9%. If the portfolio manager increases the weight of the risky asset to 130%, then the expected return of the portfolio is closest to:
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Explanation:
Explanation
When the portfolio manager increases the weight of the risky asset to 130%, this means they are borrowing at the risk-free rate to invest more in the risky asset. The weight of the risk-free asset becomes negative.
Calculation:
- Weight of Asset A (risky) = 130% = 1.3
- Weight of Asset B (risk-free) = 1 - 1.3 = -0.3
Expected return formula: [\text{Expected Return} = (w_A \times r_A) + (w_B \times r_B)] [\text{Expected Return} = (1.3 \times 14%) + (-0.3 \times 9%)] [\text{Expected Return} = 18.2% - 2.7% = 15.5%]
Concept Explanation:
- This scenario represents leveraging the portfolio by borrowing at the risk-free rate
- The capital market line allows investors to move beyond the simple combination of risk-free and risky assets by borrowing
- A weight of 130% in the risky asset means the investor is borrowing 30% of their capital at the risk-free rate to invest more in the risky asset
- The negative weight on the risk-free asset represents the borrowing position
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