Bruce Johansen, CFA, is currently fully invested in the market portfolio that lies on the capita! market line (CML). Johansen desires to increase the expected return from his portfolio. Johansen is risk aversebut willing to accept higher risk if he can increase the expected return from his portfolio. According to capital market theory, Johansen can meet his risk and return objectives best by:
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A. B. C.Explanation
According to capital market theory, an investor can increase the expected return from their portfolio by taking on higher risk. However, this increase in expected return should be balanced with the investor's risk aversion.
In the given scenario, Bruce Johansen is already fully invested in the market portfolio that lies on the Capital Market Line (CML). The CML represents the efficient frontier of risky assets, offering the highest expected return for a given level of risk. Since Johansen desires to increase the expected return from his portfolio, he needs to consider options that allow for higher risk-taking.
Let's analyze the answer choices:
A. Allocating a higher proportion of the portfolio to higher-risk assets: By allocating a higher proportion of the portfolio to higher-risk assets, Johansen would indeed be taking on more risk. However, this answer choice does not consider the fact that Johansen is already fully invested in the market portfolio lying on the CML. The CML represents the optimal risk-return tradeoff, so reallocating the portfolio to higher-risk assets might not be the best approach.
B. Borrowing at the risk-free rate to invest in the risky market portfolio: This answer choice suggests leveraging or borrowing funds at the risk-free rate to invest in the risky market portfolio. By doing so, Johansen can increase the amount of funds invested in the market portfolio, effectively amplifying the potential returns. This strategy, known as leverage, allows Johansen to increase the risk and potential return of his portfolio without changing the asset allocation. However, it's important to note that leveraging also increases the downside risk, so Johansen needs to be aware of this tradeoff.
C. Owning the risky market portfolio and lending at the risk-free rate: This answer choice suggests owning the risky market portfolio (which Johansen is already fully invested in) and lending at the risk-free rate. By lending at the risk-free rate, Johansen can earn a risk-free return in addition to the returns from the risky market portfolio. This strategy is known as risk-free lending or risk-free arbitrage. By combining the returns from the risky portfolio and the risk-free lending, Johansen can achieve a higher overall expected return without taking on additional risk.
In summary, the best option for Johansen to increase the expected return from his portfolio, while considering his risk aversion, is option C. By owning the risky market portfolio and lending at the risk-free rate, he can earn a risk-free return in addition to the returns from the market portfolio, thus achieving a higher expected return without taking on more risk.