Borrowing and Lending Rates

Borrowing and Lending Rates

Borrowing and Lending Rates

Borrowing and Lending Rates

Equally unrealistic is the assumption of identical borrowing andlending rates for the investor. The risks involved in lending moneyto the federal government are less than the risks of lending moneyto ordinary investors, and investors therefore pay higher rates of inter est on borrowed funds than they receive through investment in riskless.

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The amount of reduction in the slope of the line beyond the point of tangency obviously depends upon the magnitude of the difference between the borrowing rate for the investor and the lending rate, and thisdifference depends in part upon the credit rating of the investor. It isalso realistic to acknowledge that the rate paid by the investor dependsin part on the amount borrowed. This results in an extrapolation beyond the point of tangency which is curvilinear rather than linear.

The most visible professionally managed portfolios are mutualfunds, and it is not surprising, therefore, that most research in thefield of investments relating to portfolios is based upon mutual funds.Earlier, in studies of mutual funds were discussed to seewhether their performance was consistent with the efficient market hypothesis. Here, the performance of mutual funds is discussed to testthe explanatory power of Sharpe's capital asset pricing model.

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There are two excellent studies of mutual fund performance whichexplicitly discuss the nature of the relationship between the rate ofreturn on portfolios and their riskiness through time. Both are in sub stantial conformity with the implications of Sharpe's model. The firststudy was by Sharpe himself.He computed average annual rates ofreturn and standard deviations of those returns for 34 mutual fundsfor the years 1954-63. The model implies that higher risk portfolios,on the average, will have higher returns. Sharpe's inquiry indicatesthat this was true for the 34 funds during the period studied. Thecorrelation between the average returns and their standard deviationswas +0.836 indicating that about two thirds of the differences inreturns were "explained" by differences in risk.

Further, the relationship between returns and risk was approximately linear, as implied by the model, except for the region of highrisk. A possible explanation is that the high-risk portfolios were lessefficiently diversified than the others.

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