Consider two investors: Investor-1 (henceforth Inv-1) and Investor-2 (henceforth Inv-2). Risk-free rate for Inv-1 is 5%. Return on risky portfolio is 12%. Inv-1 invests $20,000 in risk-free asset and $30,000 in the risky portfolio. Inv-2 has $40,000 and borrows additional $20,000 at 6%2 and invests the entire $60,000 in risky portfolio.
(a) For Inv-1 draw the capital market line and show the approximate point where the indifference curve of Inv-1 is tangent to the Capital Market Line (CML)
(b) Compute the expected return of Inv-1’s portfolio comprising risk-free asset and risky portfolio.
(c) Draw capital allocation line for Inv-2 (equivalently draw the CML with different lending rate (5%) and borrowing rate (6%)) and show the approximate point where the indifference curve of Inv-2 is tangent to the CML.
(d) Compute the expected return of Inv-2’s portfolio comprising risky portfolio only.