Exam 8: Portfolio Theory and the Capital Asset Pricing Model

Explain the term market risk.

Beta measures the marginal contribution of a stock to the risk of a well-diversified portfolio.

Risk-free U.S. Treasury bills have a beta greater than zero.

Investments A and B both offer an expected rate of return of 12. The standard deviation of A is 30 percent and that of B is 20 percent. If an investor wishes to invest in either A or B, then the investor should

Florida Company (FC)and Minnesota Company (MC)are both service companies. Their stock returns for the past three years were as follows: FC: −5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. Calculate the standard deviations of returns for FC and MC. (Ignore the correction for the loss of a degree of freedom set out in the text.)

If the expected return of stock A is 12 percent and that of stock B is 14 percent, and both have the same variance, then nondiversified investors would prefer stock B to stock A.

The distribution of daily returns over short periods for stocks is more closely related to the normal distribution than the lognormal distribution.

In practice, one would generate efficient portfolios using

The distribution of returns, measured over long intervals, like annual returns, is best approximated by the

A common criticism of the CAPM is that it

It is not possible to earn a return that is above the efficient frontier of common stocks without the existence of a risk-free asset or some other asset that is uncorrelated with your portfolio assets.

Assume the following data for a stock: Risk-free rate = 5 percent; beta (market)= 1.5; beta (size)= 0.3; beta (book-to-market)= 1.1; market risk premium = 7 percent; size risk premium = 3.7 percent; and book-to-market risk premium = 5.2 percent. Calculate the expected return on the stock using the Fama-French three-factor model.

Where would underpriced and overpriced securities plot on the SML (security market line)?

If a stock were overpriced, it would plot

Assume the following data for a stock: Beta = 0.9; risk-free rate = 4 percent; market rate of return = 14 percent; and expected rate of return on the stock = 13 percent. Then the stock is

Briefly explain the term risk-free rate of interest.

Florida Company (FC)and Minnesota Company (MC)are both service companies. Their stock returns for the past three years were as follows: FC: −5 percent, 15 percent, 20 percent; MC: 8 percent, 8 percent, 20 percent. What is the variance of a portfolio with 50 percent of the funds invested in FC and 50 percent in MC? (Ignore the correction for the loss of a degree of freedom set out in the text.)

How can an investor earn more than the return generated by the tangency portfolio and still stay on the security market line?

According to the CAPM, the market portfolio is a tangency portfolio.

Explain why purchasing a high-growth mutual fund can be a worse investment than taking out a second mortgage on a home and investing in the market index.