Simple question really, but I'm very confused by the starting point. Let's assume that we have a portfolio whose excess returns can be described by the following equation from the single index model:

E(R) = .04 + 1.4*(Risk Premium of the Market)

Obviously, alpha is .04, beta is 1.4. This portfolio is underpriced, as it lies outside the Security Market Line and has a positive alpha.

Now, if I wanted to exploit this and earn that .04 alpha, I understand I'd create some sort of tracking portfolio to mimic the 1.4 beta. This is where I'm confused, I see these questions and they state that we'd borrow .4 at the risk free rate and buy a portfolio with 1.4 beta. This is where all my questions start.

How does this make any sense?? Firstly, what's the base assumption of how much money we have? 1 unit? This means 1 unit lets us buy a portfolio of beta = 1? If we borrow .4 at the risk-free rate, how does that allow us to buy a 1.4 beta portfolio (doesn't this assume price is strictly proportional to beta and NOTHING else?)

Any insight would be very much appreciated.


Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.