It would be great if somebody could clarify the below on Vol 5-Reading 42 (CFA-Material) Risk of Foreign market portfolio (Pg 348-351)-When the beta of the portfolio is reduced to zero- how does it earn the risk free rate. Ideally it should be earning only some alpha-which should be close to zero, if the original portfolio which is hedged by selling futures is well diversified
E®=rf+B(ERP) if B=0, the E®=rf.
Any risk free asset should generate risk free rate. If you reduce the beta of a equity forigen market portfolio to zero by hedging (or some thing else), your expected return is the risk free rate.
the equity risk premium would be zero if beta is 0 since you would borrow at the risk free rate to invest in the equity market also
Thanks guys. Theoretically when beta is zero-asset return is the risk free rate. But in an example in pg (323-324) of Vol 5-Reading 42 -when beta of portfolio is reduced to zero-its return is zero and not the risk free rate. There is some differences in the expected return of zero beta portolio in different places in the cfa exam. Please let me know if i am wrong.
You’re long the stock portfolio and short futures that mimics the portfolio. You hold the stock at the spot price and you’re going to sell it (theoretically) at the futures price. The equation for futures price tells you that you will earn the risk free rate. Forget about beta being zero, that’s only relevant for calculating the # of contracts needed.