10 Questions
According to the Capital Asset Pricing Model (CAPM), what is the expected return of a stock with a beta of zero?
The risk-free rate
If an analyst determines that a stock's expected return is higher than its expected return as determined by the CAPM, what is the most likely conclusion?
The stock is overvalued
Which of the following is NOT an assumption of the Capital Asset Pricing Model (CAPM)?
Investors have the same risk appetite
If a portfolio has a beta of 1.2, what is its relative risk compared to the market portfolio?
Greater than the market risk
Which performance measure is most useful for evaluating the performance of a portfolio manager who actively manages a portfolio?
Jensen's alpha
What determines the optimal portfolio of an investor?
The indifference curve with the highest utility
What type of risk is eliminated in a fully diversified portfolio?
Nonsystematic risk but not systematic risk
What does the security market line show?
An asset's expected return based on its systematic risk only
What is the capital allocation line (CAL) best described as?
Representing portfolios that consist of the optimal risky portfolio and the risk-free asset
Why are all investors price takers according to the capital asset pricing model?
Traders cannot influence the value of an asset
Study Notes
Portfolio Risk and Return
- An investor's optimal portfolio is determined by the indifference curve with the highest utility.
- Portfolios on the capital market line are constructed using a combination of the optimal risky portfolio and the risk-free asset.
- A fully diversified portfolio eliminates nonsystematic risk but not systematic risk.
- The security market line shows an asset's expected return based on the asset's systematic risk.
- The market model is used for determining the expected return of a security.
Portfolio Performance Measures
- The Sharpe ratio is a meaningful standalone metric for portfolio performance.
- The Treynor ratio and M-squared are not meaningful standalone metrics.
Capital Asset Pricing Model (CAPM)
- According to the CAPM, all investors are price takers because traders cannot influence the value of an asset.
- The CAPM assumes that investors have homogeneous expectations and are price takers.
- If an analyst determines a stock's expected return by another method and that return is higher than the stock's expected return as determined by the CAPM, then the analyst most likely should sell the stock since it is overvalued.
Calculating Expected Return
- Using the CAPM, if a security's expected return is 20%, its beta is 1.3, and the risk-free rate is 4%, then the market risk premium is closest to 12.3%.
- The market risk premium is the expected return of the market minus the risk-free rate.
Portfolio Risk
- The market portfolio's systematic variance is greater than its nonsystematic variance.
- If an asset has a beta that is equal to the average beta of all assets, then its risk level is equal to market risk.
CAPM Assumptions
- An assumption of CAPM is that investments are infinitely divisible.
- Another assumption of CAPM is that investors are rewarded only for systematic risk.
Portfolio Management
- A portfolio manager should add only funds with Jensen's alpha above −0.5% and an ex post Treynor ratio greater than 3%.
- The manager's most appropriate choice is Fund Y based on the given data.
This quiz assesses understanding of portfolio risk and return, including determining optimal portfolios and constructing portfolios on the capital market line. It covers topics such as investor preferences, risk-free assets, and global market indices.
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