63 - Portfolio Risk and Return Part 2

Question 1

For an investor to move further up the Capital Market Line than the market portfolio, the investor must:

Answer 1

Portfolios that lie to the right of the market portfolio on the capital market line (“up” the capital market line) are created by borrowing funds to own more than 100% of the market portfolio (M).

The statement, “diversify the portfolio even more” is incorrect because the market portfolio is fully diversified.

(Module 63.1, LOS 63.b)

Question 2

The expected market premium is 8%, with the risk-free rate at 7%. What is the expected rate of return on a stock with a beta of 1.3?

Answer 2

Market premium is E(R) - Rf

RRStock = Rf + (RMarket – Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate, and (RMarket – Rf) = market premium

Here, RRStock = 7 + (8 × 1.3) = 7 + 10.4 = 17.4%.

Question 3

Which of the following is an assumption of the Capital Asset Pricing Model (CAPM)?

Answer 3

The CAPM assumes all investors are price takers and no single investor can influence prices. The CAPM also assumes markets are free of impediments to trading and that all investors are risk averse and have the same one-period time horizon.

(Module 63.2, LOS 63.f)

Question 4

Risk aversion means that an individual will choose the less risky of two assets:

Answer 4

Investors are risk averse. Given a choice between assets with equal rates of expected return, the investor will always select the asset with the lowest level of risk. Risk aversion does not imply that an investor will choose the less risky of two assets in all cases, or that an investor is unwilling to accept greater risk to achieve a greater expected return.

(Module 62.2, LOS 62.d)

Question 5

In a two-asset portfolio, reducing the correlation between the two assets moves the efficient frontier in which direction?

Answer 5

Reducing correlation between the two assets results in the efficient frontier expanding to the left and possibly slightly upward. This reflects the influence of correlation on reducing portfolio risk.

Question 6

An investor’s wealth is approximately 50% in bonds and broad-based equities and 50% in shares of a company she founded. Which of the following measures of risk-adjusted returns is least appropriate for this investor’s portfolio?

Answer 6

Jensen’s alpha is based on systematic risk and is not appropriate for a portfolio with a 50% concentration in a single entity (i.e., not well diversified). Both the Sharpe ratio and the M-squared measure are based on total portfolio risk and are appropriate for a portfolio that is not well diversified.

(Module 63.2, LOS 63.i)