Modern Portfolio Theory and Capital Asset Pricing Model - Foundations Chapter 5 Flashcards
5.1 Is the market portfolio the only efficient portfolio that can be formed?
5.1 No
5.4 Here are the betas for three stocks:
* 3M 1.14
* IRobot Corporation 1.49
* Applied Materials Inc. 1.64
The stock of which company is the most aggressive?
5.4 The most aggressive stock is the one with the largest beta, Applied Materials, Inc.
5.11 What are the major assumptions needed to establish CAPM (as made by Sharpe, Lintner, and Mossin)?
5.11
* Investments are perfectly divisible; * They are no transaction costs and/or taxes; * Full and costless information is available to all investors; * The lending and borrowing rates are equal, and are the same for all investors; and * Each investor can borrow or lend any amount at the market rate.
5.12 What is the two-fund separation theorem?
5.12 According to capital market theory, all investors will invest in two assets: the risk-free asset and the market portfolio.
5.13 What is the relationship between CAPM and the market model?
5.13 These models are frequently confused because they both demonstrate a relationship between every asset and the market portfolio. The market model is an empirical model based on real-ized rates of return, whereas CAPM is based on expected and unobserved variables. The market model also pro-vides a method of decomposing asset returns into two components: a systematic (or market) component and a residual (or non-market) component: rP = aP + bP rM + eP where rP = RP - r (or the excess return of the portfolio return RP over the risk-free rate r), and rM = RM - r (or the excess return of the market portfolio RM over the risk-free rate r). The residual component eP is uncorrelated with the market excess return rM . The systematic component is beta multiplied by the market excess return. The market model thus appears to be a natural framework for esti-mating beta. CAPM is an equilibrium pricing model, which suggests that each asset is priced so that its expected return com-pensates for its contribution to the risk of the market portfolio. The asset’s expected return is thus found to be proportional to its beta. For a well-diversified portfolio, an asset’s risk contribution will approximate its risk con-tribution to the market portfolio.
5.14 What is the difference between the Capital Market Line and the Security Market Line?
5.14 The CML shows the relationship between expected returns on an efficient portfolio and its standard deviation (See Figure 5.2). Another important relation-ship can be developed from the CML called the security market line (SML). The SML gives the relationship between the expected return for individual assets (not portfolios) and risk. However, in the SML the risk measure is systematic risk as proxied by beta, not by standard deviation as in the CML.
5.15 Define systematic risk and nonsystematic risk.
5.15 Systematic, or undiversifiable, risk is that portion of the risk that is associated with market fluctuations and there-fore cannot be reduced by diversification. Non-systematic, or diversifiable, risk is that portion of risk that can be eliminated by combining the security in ques-tion with others in a diversified portfolio.
5.17 In the Sortino ratio, is performance compared to the performance of a risk-free asset or a client-designated benchmark?
5.17 The Sortino ratio compares a portfolio’s performance to that of a client-designated benchmark which is a mini-mum return that the client specifies.
5.18 The beta of a security estimated from historical returns is equal to the true beta of the security. True or false? Discuss.
5.18 This statement is false. The beta of a security obtained from past data is only an estimate of the true beta, which is unknown. The estimate is subject to statistical estima-tion errors and the true beta, at best, can be said to fall within a confidence interval with a given probability (the confidence level).
