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26 March, 18:50

describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier. Additionally, explain how might the magnitude of the market risk premium impact people's desire to buy stocks?

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  1. 26 March, 19:05
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    Answer: Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase returns beyond the efficient frontier.

    Risk premium is defined as excess return over risk free rate by taking extra risk. A risk-free asset has zero risk, so risk premium on these assets is zero. As risk level of investment increases, risk premium on investment also increases.

    The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate. The market risk premium is equal to the slope of the security market line (SML), a graphical representation of the capital asset pricing model (CAPM). CAPM measures required rate of return on equity investments, and it is an important element of modern portfolio theory and discounted cash flow valuation.
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