Explanation

A risk-seeking investor would want to take on more risk than the optimal risky portfolio to achieve higher expected returns. This is done by borrowing at the risk-free rate and investing more than 100% of wealth in the risky portfolio, which is called leveraging.

Key concepts:

• Capital Allocation Line (CAL): Shows all possible combinations of the risk-free asset and the optimal risky portfolio
• Risk-seeking investor: Wants higher returns and is willing to take more risk
• Leverage: Borrowing at the risk-free rate to invest more than 100% in the risky portfolio

Analysis of options:

• Option A: Lending 100% at risk-free rate (5% return) - This is for risk-averse investors, not risk-seeking
• Option B: Investing 100% in optimal risky portfolio (15% return, 20% risk) - This is the market portfolio point on CAL
• Option C: Borrowing 25% at risk-free rate and investing 125% in risky portfolio - This creates leverage and moves up the CAL beyond the optimal risky portfolio

Expected return for Option C:

• Investment in risky portfolio: 125%
• Borrowing: 25% at 5%
• Expected return = (1.25 × 15%) - (0.25 × 5%) = 18.75% - 1.25% = 17.5%

Risk for Option C:

• Standard deviation = 1.25 × 20% = 25%

Since a risk-seeking investor wants higher returns than the optimal risky portfolio offers, they would choose to leverage by borrowing at the risk-free rate and investing more than 100% in the risky portfolio, making Option C the correct choice.