Deck 7: The Capital Asset Pricing Model

Question 1

What is true about the risk free rate?

A)The risk free rate represents the interest an investor would expect from an absolutely risk free investment over a specified period of time.
B)The risk free rate is the minimum return that an investor expects for any investment. A rational investor will not accept any additional risk unless the potential rate of return is greater than the risk free rate.
C)The risk-free rate does not truly exist because even the safest investments carry a very small amount of risk.
D)All of the above.

Answer 1

The risk free rate represents the interest an investor would expect from an absolutely risk free investment over a specified period of time.
The risk free rate is the minimum return that an investor expects for any investment. A rational investor will not accept any additional risk unless the potential rate of return is greater than the risk free rate.

Question 2

According to the CAPM model: Expected Return = Risk free rate + Risk premium. For investors like David, the model compensates the time value of his money and risk when he invests into any investment over a period of time. What does the risk free rate compensate David for?

A)The time value of his money.
B)The risk he takes.
C)Both the time value of his money and the risk he takes.
D)None

Answer 2

The time value of his money.

Question 3

Beta provides a measure of the "systematic risk" of the portfolio. This is the part of the risk that cannot be diversified away. Given that the portfolio risk is measured by its covariance, why are investors still willing to hold assets with lower expected returns?

A)Assets with low expected returns now can yield higher returns in the future.
B)Investors do not have any other better alternatives.
C)Although these assets have low expected returns, they are less risky due to low overall systematic risk.
D)Low expected returns attract less investors, so it is difficult to sell them.

Answer 3

Although these assets have low expected returns, they are less risky due to low overall systematic risk.

Question 4

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. However the CAPM model only compensates investors for taking systematic risk, not specific risk. Why is this the case?

A)Because the CAPM favors systematic risk.
B)Because systematic is diversifiable, while specific risk is undiversifiable.
C)Because systematic is undiversifiable, while specific risk is diversifiable.
D)Because investors only accept systematic risk, not specific risk.

Question 5

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. What is the difference between systematic risk and specific risk?

A)Systematic risk is the risk of holding the market portfolio and specific risk is the risk which is unique to an individual asset.
B)Both risks correlate with movements in the market.
C)Systematic risk can be diversified away while specific risk cannot be.
D)There is no difference between them.

Question 6

Beta ? is the measure of systematic risk and it can be applied to market timing. Consider the following situation: Mike is an investor and he expects that the market will go down. How should he react to the expectation?

A)He wants to move into higher beta stocks.
B)He wants less exposure to the stock market and hence should buy stocks with lower betas.
C)He will not do anything because the market will go up and it will not affect his situation.
D)He will not invest anymore because he loses confidence in the market.

Question 7

What of the following assumptions is NOT true when conducting analysis using CAPM model?

A)Market is frictional.
B)Expectations are homogeneous.
C)Investors hold risky assets in the same proportions. Their CML is the same and they all have market portfolio M.
D)Market is in equilibrium.

Question 8

In finance, the beta of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole. When an asset has a beta value of 0, which of the following is true?

A)The asset's price is not at all correlated with the market or the asset is independent of market.
B)The asset generally follows the market.
C)The asset inversely follows the market, but it generally decreases in value if the market goes up and vice versa.
D)None of the above is true.

Question 9

Alpha is a risk-adjusted measure of the active return on an investment. It is a return in excess of the compensation for the risk occurred and thus, commonly used to assess active managers' performances. The higher the alpha,...

A)The worse the manager.
B)The better the manager.
C)The same the manager.
D)The more risk.

Question 10

According to the CAPM, portfolios may randomly outperform or underperform the market from one year to the next. However, when portfolios consistently outperform the market over the years, which of the following is NOT true about alpha?

A)Alpha is the difference in the expected returns of the portfolio that is performing well over the years and that of the market portfolio.
B)Alpha shows a persistent positive contribution to a portfolio's expected return due to the manager's skill.
C)Alpha cannot be negative.
D)If alpha is positive, it means that investment portfolios outperform the market portfolio. If alpha is negative, it means that investment portfolios underperform the market portfolio.
E) All of the above.

Question 11

The Volatility Index (VIX) is the most popular measure of stock market volatility. Mike is an investor and despite the fact that the VIX is high, he still decides to buy stocks. He makes that decision because

A)The VIX history shows that he should do so.
B)His own intuition tells him to do so.
C)His personal savings allows him to do so.
D)He has nothing else do to.

Question 12

Britney is a trader and she holds her portfolio of commodity forwards. She knows what the market value is today, but she is uncertain about its market value a week from today. What does it mean?

A)Britney faces market risk.
B)Since market value is unpredictable, Britney should not hold the portfolio but should sell it soon.
C)Britney's uncertainty can be managed by long term focus with careful planning and investment.
D)Her trading activity is agreed to by a contract so she doesn't face any risk in the future.