SML and Alpha Quiz from Investments Textbook

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Questions and Answers

What is the Security Market Line (SML) graphed as?

  • A curve connecting all possible portfolios in the market
  • A hyperbolic curve representing the relationship between expected return and beta
  • An exponential curve showing the relationship between risk and return
  • A straight line connecting the risk-free rate to the market portfolio (correct)

Which of the following best describes the Capital Market Line?

  • It shows the relationship between expected return and market risk premium
  • It is a curve representing the equilibrium between expected return and beta
  • It connects the risk-free rate to a tangency portfolio in the market
  • It represents a set of portfolios that achieve the highest possible return for a given level of risk (correct)

In the context of CAPM, what does alpha represent?

  • The expected return of an asset given its beta
  • The systematic risk of an asset
  • The market risk premium
  • The difference between an asset's actual return and its expected return based on its beta (correct)

If an asset lies below the Security Market Line (SML), what does it imply?

<p>The asset's return is less than what would be predicted by its beta (C)</p> Signup and view all the answers

Which line on a graph represents the relationship between expected return and beta according to CAPM?

<p>Security Market Line (SML) (D)</p> Signup and view all the answers

What does a higher slope of the Security Market Line (SML) indicate?

<p>Higher systematic risk in the market (B)</p> Signup and view all the answers

How is risk typically measured in relation to beta on the Security Market Line (SML)?

<p>With respect to market returns (A)</p> Signup and view all the answers

What does a point above the Capital Market Line indicate?

<p>An overvalued asset in the market (C)</p> Signup and view all the answers

'Beta' in relation to CAPM represents:

<p>'Beta' measures an asset's volatility relative to the market (A)</p> Signup and view all the answers

What does 'Alpha' being positive indicate in relation to CAPM?

<p>The asset has outperformed the market based on its systematic risk. (A)</p> Signup and view all the answers

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Study Notes

  • Alpha is the difference between a stock’s expected return and its required return according to the Security Market Line (SML).

  • Stocks with non-zero alphas do not lie on the SML, indicating market inefficiency.

  • The alpha for Cisco during 2000–2017 was estimated at -0.29% with a standard error of 0.5%, which was statistically insignificant.

  • Alpha represents a risk-adjusted performance measure for historical returns in the Capital Asset Pricing Model (CAPM).

  • It is difficult to accurately estimate alpha without a long data series, and individual stock alphas have little persistence.

  • The Capital Asset Pricing Model (CAPM) helps identify the portfolio that maximizes Sharpe ratio for investment.

  • Tangency portfolio is where the risk-free asset combines with the investable universe, optimizing return and risk.

  • Efficient Frontier is the ideal balance between risk and return in portfolios, with the Tangency portfolio at the peak.

  • Adding assets to a portfolio will improve the Sharpe ratio if the risk is reduced.

  • Different companies have varying betas with respect to the S&P 500, indicating their volatility compared to the market.

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