A3

Question 1

2 Shortcomings of Markowitz model

Answer 1

As number of securities increases, number of variables to be calculated increases dramatically

Due to large number of required estimates, some variables may be incorrectly estimated and model has nonsensical results

Question 2

Single Index Model Advantages

Answer 2

Less # of estimates
Allows for specialization of effort in security analysis
A lot of data in broad index to estimate parameters

Question 3

Components of risk premium

Answer 3

Systemic risk prem (Beta*E(R))

Nonmarket prem: alpha

Question 4

How to estimate Betas and why necessary

Answer 4

Betas chnage over time
Simple model: a+bPastBeta
Additional Vars: a+b1PastBeta+b2FirmSize+b3DebtRatio

Question 5

Single index model purpose

Answer 5

can estimate alphas, betas > expected return, variance of the portfolio, and then optimal risky portfolio