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solution

A market portfolio with expected return 12% and volatility 25%. The risk-free rate is 7%. Another asset X with expected return 15% with volatility 50% is available on the market.

(a) (2 points) Draw the CML and locate asset M and X.

(b) (2 points) Use the market portfolio and the risk-free asset to construct a portfolio, such that the expected return replicates asset X. Assume one can freely borrow and lend at risk-free rate.

(c) (3 points) If the risk-free borrowing rate is 10% instead, with the same risk-free lending rate 7%, draw the new CML and locate X again. How much do you need to borrow from the risk-free rate to reach a portfolio with the same expected return as asset X?

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