9.2 Portfolio Risk and Return: Part 2

Question 1

A key principle of capital market theory is

Answer 1

in order to generate higher returns, investors must be willing to tolerate greater risk

Question 2

Capital market theory assumes homogeneity of expectations

Answer 2

meaning that all investor have the same economic expectations about investment characteristics such as prices, cash flows, and discount rates for all assets.

If this assumption holds, all investors will conduct the same analysis, which should produce the same optimal portfolios of risky assets.

Question 3

If a market is informationally efficient

Answer 3

prices reflect all publicly available information and provide unbiased estimates of future discounted cash flows.

Under such conditions, assets will earn their consensus required rate of return and investors have no incentive to seek excess returns.

Investors who believe in market efficiency will adopt a passive approach, simply buying and holding the market portfolio.

Question 4

The market risk premium can be calculated as

Answer 4

the difference between the expected return on the market portfolio and a proxy for the risk-free rate, such as the yield on short-term US Treasury bills.

Question 5

The capital market line (CML)

Answer 5

simply a capital allocation line with the risky portfolio being the market portfolio.

Graphically, it is the line tangent to the efficient frontier constructed from all available risky assets

Question 6

Systematic risk (also called non-diversifiable risk or market risk)

Answer 6

It includes risks like interest rates and economic cycles that cannot be avoided

Question 7

Nonsystematic risk

Answer 7

also called company-specific, industry-specific, or diversifiable risk.

Diversification can reduce or even eliminate nonsystematic risk.

Question 8

total variance

Answer 8

systematic variance + nonsystematic variance

Question 9

A return-generating model

Answer 9

estimates the expected return of a given security

Question 10

Multi-factor models

Answer 10

allow for more than one variable.

The factors could be macroeconomic, fundamental, or statistical, although statistical variables that have no macroeconomic or fundamental meaning are usually discarded

Question 11

The three-factor model

Answer 11

created by Fama and French

includes factors for sensitivity to market risk as well as for company size and style (growth vs. value)

Question 12

Carhart’s four-factor model

Answer 12

includes the same factors that appear in the Fama and French model and adds a momentum factor.

Question 13

A single-index model

Answer 13

generated return expectations using an asset’s sensitivity to a market index as the only factor.

Because of its simplicity, the single-index model can be used to create the capital market line (CML

Question 14

The market model

Answer 14

the most common implementation of the single-index model.

It is similar to the single-index model, but it allows for an easier estimation of beta.

Question 15

Beta

Answer 15

measures the sensitivity of an asset’s return to the market return

it is the covariance between the security return and the market return divided by the market variance.

A positive beta indicates the asset return will move with the market

Question 16

The capital asset pricing model (CAPM)

Answer 16

simply the single-index model

It emphasizes beta as the primary determinant of a security’s expected return.

Question 17

Assumptions of the CAPM

Answer 17

1. Investors are risk-averse, utility-maximizing, and rational individuals
2. Markets are frictionless – no taxes or transaction costs
3. All investors plan for same single holding period
4. Investors have homogeneous expectations
5. Investments are infinitely divisible
6. Investors are price takers

Question 18

The security market line (SML)

Answer 18

constructed with beta on the horizontal axis and expected return on the vertical axis

The slope is the market risk premium

the SML applies to any security, not just efficient portfolios

The security market line also applies to a portfolio of securities

Question 19

Theoretical Limitations of the CAPM

Answer 19

1. It is a single-factor model that only includes beta risk.
2. It is a single-period model that does not consider multi-period implications of decisions.

Question 20

Practical Limitations of the CAPM

Answer 20

1. The true market portfolio includes all assets, some of which are not investable.
2. Proxies for the market portfolio can generate different return estimates.
3. Beta risk estimates require a long history but may not be applicable for future risk estimates.
4. CAPM is a poor predictor of returns.
5. Homogeneity of investor expectation is assumed to generate a single optimal risky portfolio.

Question 21

Extensions to the CAPM

Answer 21

Theoretical models use the same principles but expand the number of risk factors. An example is the arbitrage pricing theory (APT).

Fama and French found three factors (relative size, relative book-to-market value, and beta) that seemed to explain past returns. Carhart added a fourth factor, which considers momentum

Question 22

CAPM can also be used in portfolio performance evaluations. This is important to both investors and money managers.

The following four ratios are commonly used in risk and return performance evaluation:

Answer 22

Sharpe Ratio

Treynor Ratio

M-Squared

Jensen’s Alpha

Question 23

Sharpe Ratio

Answer 23

This reward-to-variability ratio is the slope of the capital allocation line. It is an easy measure to use, but it suffers from two shortcomings:

The Sharpe ratio uses total risk rather than systematic risk.

The ratio is meaningless but for comparisons with other Sharpe ratios.

Question 24

Treynor Ratio

Answer 24

This is like the Sharpe ratio, but it substitutes beta risk for total risk. Like the Sharpe ratio, it is only meaningful if both the numerator and denominator are positive.

Question 25

M-Squared

Answer 25

based on total risk like the Sharpe ratio.

The portfolio return is adjusted to what it would be at the same risk level as the market.

If M^2 is greater than the market return, then the portfolio outperformed the market on a risk-adjusted basis.

Question 26

Jensen’s Alpha

Answer 26

As with the Treynor ratio, this measure is based on systematic risk. It is the difference between the actual return and risk-adjusted return using beta.

Portfolios that outperform the market will have a positive Jensen’s Alpha

Question 27

The security characteristic line (SCL)

Answer 27

a plot of the excess return of the security to the excess return of the market

The slope is beta and the intercept is alpha.

Question 28

The line depicting the total risk and expected return of portfolio combinations of a risk-free asset and any risky asset is the:

a) security market line.

b) capital allocation line.

c) security characteristic line

Answer 28

b) capital allocation line.

A capital allocation line (CAL) plots the expected return and total risk of combinations of the risk-free asset and a risky asset (or a portfolio of risky assets).

Question 29

With respect to capital market theory, an investor’s optimal portfolio is the combination of a risk-free asset and a risky asset with the highest:

a) expected return.

b) indifference curve.

c) capital allocation line slope.

Answer 29

b) indifference curve.

Investors will have different optimal portfolios depending on their indifference curves. The optimal portfolio for each investor is the one with highest utility; that is, where the CAL is tangent to the individual investor’s highest possible indifference curve.

Question 30

Which of the following statements most accurately defines the market portfolio in capital market theory? The market portfolio consists of all:

a) risky assets.

b) tradable assets.

c) investable assets.

Question 31

With respect to the pricing of risk in capital market theory, which of the following statements is most accurate?

a) All risk is priced.

b) Systematic risk is priced.

c) Nonsystematic risk is priced.

Answer 31

b) Systematic risk is priced.

Question 32

The sum of an asset’s systematic variance and its nonsystematic variance of returns is equal to the asset’s:

a) beta.

b) total risk.

c) total variance.

Answer 32

c) total variance.

The sum of systematic variance and nonsystematic variance equals the total variance of the asset. References to total risk as the sum of systematic risk and nonsystematic risk refer to variance, not to risk.

Question 33

With respect to return-generating models, the intercept term of the market model is the asset’s estimated:

a) beta.

b) alpha.

c) variance.

Answer 33

b) alpha.

Question 34

With respect to return-generating models, the slope term of the market model is an estimate of the asset’s:

a) total risk.

b) systematic risk.

c) nonsystematic risk.

Answer 34

b) systematic risk.

Question 35

the graph of the capital asset pricing model is the:

a) capital market line.

b) security market line.

c) security characteristic line.

Answer 35

b) security market line.

The security market line (SML) is a graphical representation of the capital asset pricing model, with beta risk on the x-axis and expected return on the y-axis.

Question 36

With respect to capital market theory, which of the following statements best describes the effect of the homogeneity assumption? Because all investors have the same economic expectations of future cash flows for all assets, investors will invest in:

a) the same optimal risky portfolio.

b) the Standard and Poor’s 500 Index.

c) assets with the same amount of risk.

Question 37

With respect to capital market theory, which of the following assumptions allows for the existence of the market portfolio? All investors:

a) are price takers.

b) have homogeneous expectations.

c) plan for the same, single holding period.

Answer 37

b) have homogeneous expectations.

Question 38

Which of the following performance measures is consistent with the CAPM?

a) M2.

b) Sharpe ratio.

c) Jensen’s alpha.

Answer 38

c) Jensen’s alpha.

Question 39

Which of the following performance measures is most appropriate for an investor who is not fully diversified?

a) M2.

b) Treynor ratio.

c) Jensen’s alpha.

Answer 39

a) M2.

Question 40

Portfolio managers, who are maximizing risk-adjusted returns, will seek to invest less in securities with:

a) lower values for nonsystematic variance.

b) values of nonsystematic variance equal to 0.

c) higher values for nonsystematic variance.

Answer 40

c) higher values for nonsystematic variance.

Since managers are concerned with maximizing risk-adjusted returns, securities with greater nonsystematic risk should be given less weight in the portfolio.

Question 41

hich of the following performance measures most likely relies on systematic risk as opposed to total risk when calculating a risk-adjusted return?

a) Sharpe ratio

b) M-squared

c) Treynor ratio

Answer 41

c) Treynor ratio

Question 42

The slope of the security market line (SML) represents the portion of an asset’s expected return attributable to:

a) diversifiable risk.

b) market risk.

c) total risk.

Answer 42

b) market risk.

the slope of the SML is the market risk premium, E(Rm) – Rf. It represents the return of the market minus the return of a risk-free asset. Thus, the slope represents the portion of expected return that reflects compensation for market or systematic risk.

Question 43

Which of the following statements is least accurate?

A
A market portfolio has no exposure to nonsystematic risk

B
A risk-free asset has no exposure to either systematic or nonsystematic risk

C
Investors are compensated based on the total risk exposure of their portfolios

Answer 43

C
Investors are compensated based on the total risk exposure of their portfolios

Question 44

Which of the following is least likely to be specified as a factor in the Fama-French three-factor model?

A
Momentum

B
Value/growth

C
Company size

Answer 44

A
Momentum

Question 45

Which of the following is least likely to be classified as a measure of returns to total risk?

A
M2

B
Sharpe ratio

C
Treynor ratio

Answer 45

C
Treynor ratio

The Sharpe ratio and M2 are total risk performance measures.

The Treynor ratio and Jensen’s alpha are beta risk performance measures.

Question 46

Which of the following statements most accurately defines the market portfolio in capital market theory? The market portfolio consists of all:

A
risky assets.

B
tradable assets.

C
investable assets.

Answer 46

A
risky assets.

Question 47

With respect to return-generating models, the slope term of the market model is an estimate of the asset’s:

A
total risk.

B
systematic risk.

C
nonsystematic risk.

Answer 47

B
systematic risk.