Bill Turner is a security analyst for Secure-Invest Inc. The firm has concerns about the equal borrowing and lending rate assumption made by the traditional capital asset pricing model (CAPM), and, instead, tells Turner to use the zero-beta CAPM when selecting assets. Turner finds that the return on the zero-beta portfolio exceeds the risk-free rate. Which of the following most accurately describes the effect of relaxing the equal borrowing and lending assumption?
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A. B. C.Explanation
By relaxing the equal borrowing and lending assumption of the traditional Capital Asset Pricing Model (CAPM), Bill Turner is instructed to use the zero-beta CAPM. The zero-beta CAPM recognizes that there can be a difference between the borrowing and lending rates in the market. In this case, Turner finds that the return on the zero-beta portfolio exceeds the risk-free rate.
The security market line (SML) represents the relationship between the expected return and the beta of a security. The traditional CAPM assumes that the borrowing rate and the lending rate are equal, meaning there is no difference in the rates of borrowing and lending. However, by relaxing this assumption, the zero-beta CAPM allows for different borrowing and lending rates.
When the return on the zero-beta portfolio exceeds the risk-free rate, it implies that investors can earn a higher return without taking on any systematic risk. This situation is inconsistent with the traditional CAPM, where the risk-free rate is the return that investors can earn without any systematic risk.
To reconcile this inconsistency, the slope of the security market line (SML) needs to be adjusted. The slope of the SML represents the market risk premium, which is the additional return investors expect for taking on one unit of systematic risk (as measured by beta).
In this case, if the return on the zero-beta portfolio exceeds the risk-free rate, it suggests that the market risk premium is higher than what is implied by the traditional CAPM. This implies that the slope of the SML needs to be adjusted to reflect a higher market risk premium.
Therefore, the correct answer is:
A. The slope of the security market line will increase.
By relaxing the equal borrowing and lending assumption, the zero-beta CAPM recognizes that investors can earn a higher return without taking on any systematic risk. As a result, the slope of the SML needs to increase to reflect the higher market risk premium.