Vignette: CAPM is a fundamental model that can be used to calculate the expected return on an asset based upon market and the beta of the individual security. When the assumptions underlying this model change so to does the results of this model. In particular the focus is on changing the assumptions surrounding the lending and borrowing of money at the risk free rate and placing limits on short selling. When these assumptions change what will be the effect on the market portfolio, the results of the model and other relationships that the model may have. Question: Which of the following can not occur if there are constraints on short selling and borrowing at the risk free rate? a) High risk portfolios will become over concentrated in a couple of securities b) Composition of low risk and high risk portfolios are not identical c) Composition of low risk and high risk portfolios are identical d) Portfolios deemed to be low risk will generally be diversified

c

C

“C” is the answer…

there are no low risk or high risk if assumptions hold - there is only one portfolio-the market is assumptions don’t hold then there are more than one portfolio so risky and less risky cant be identical