Consider the security market line (SML)under the one-factor model.Assume Point C lies on the SML but an investor would prefer a point that also lies on the SML but is lower and to the left of Point C.How can this investor obtain that point for their portfolio?
A)Replace the lower beta stocks in the portfolio with higher beta stocks
B)Sell a portion of the portfolio and use the proceeds to purchase undervalued stocks
C)Sell the higher beta stocks in the portfolio and replace them with undervalued stocks
D)Replace the portfolio with undervalued stocks and risk-free assets
E)Replace the portfolio with a combination of a higher beta portfolio that lies on the SML and risk-free assets

Question

Quizplus · Accepted Answer

In order to obtain a point on the SML that is lower and to the left of Point C, the investor would need to construct a portfolio that has a higher expected return than their current portfolio, but with the same level of risk (as measured by beta). This can be accomplished by replacing some of the lower beta stocks in their portfolio with higher beta stocks, and also investing in risk-free assets to adjust the overall level of risk in the portfolio. Therefore, the best choice is to replace the portfolio with a combination of a higher beta portfolio that lies on the SML and risk-free assets (choice E).

Consider the Security Market Line (SML)under the One-Factor Model