Lesson 6: Capital Asset Pricing Model

Question 1

Sharpe ratio is increased only if

Answer 1

E[Ri] - rf > βp,i(E[Rp] - rf)
with βp,i = Cov(Rp, Ri)/Var(Rp)
(beta of investment i with respect to the portfolio)

Question 2

required return

Answer 2

βp,i(E[Rp] - rf)

Question 3

Efficient portfolio

Answer 3

In efficient portfolio, the return of every investment is its required return

Question 4

Efficient portfolio

Answer 4

In efficient portfolio, the return of every investment is its required return

Question 5

3 assumptions that Capital Asset Pricing Model makes

Answer 5

1. Efficient transaction: investors can buy and sell all securities at competitive market price with no transaction costs, can borrow or lend at rf
2. Rationality: investors hold only efficient portfolios, portfolio that maximize Sharpe ratio
3. Homogeneous expectations: investors have the same expectations regarding expected returns, volatilities, and correlation of securities

Question 6

Capital Market Line

Answer 6

line on the volatility / return graph going through the point (volatility 0, rf) and through the tangent portfolio point for the market portfolio

Question 7

Volatility of individual investments

Answer 7

include market risk an idiosyncratic risk (risk not correlated with the market)
-> Sharpe ratios of individuals investments are lower than the market portfolio’s Sharpe ratio
-> individual investment plot below the capital market line

Question 8

βi represents

Answer 8

the change in the return of an investment per unit change in the return of the market portfolio
(βi = dRi/dRmkt)

Question 9

Security Market Line

Answer 9

• the line in a graph of return on beta
  + its vertical intercept is the risk-free rate
  + its slope is the market portfolio’s risk premium

Question 10

How to calculate beta of the portfolio

Answer 10

βp = Σ xi * βi (xi: weighted of the investment to the portfolio)