Suppose that the interest rate on a government bond is .10, and that the market price of risk is equal to .05. In addition, suppose that, on average, the change in the rate of return on Security K from one year to the next is equal to 2.5 times the change in the rate of return on the S&P 500 over the same period.
(a) What is the reward for waiting? What is the quantity of risk in Security K?
(b) According to the capital asset pricing model, what is the equilibrium average rate of return on Security K?
(c) How much additional risk must an investor accept for each additional one percentage point of average rate of return? Describe how the investor should restructure his portfolio to gain an additional one percentage point of average rate of return.