MT 6 - Portfolio Theory and Asset Pricing

Question 1

Benefits of diversification

Answer 1

Question 2

Graph of diversification

Answer 2

Question 3

Explain what are:

1) Feasible set
2) Portfolio frontier
3) Optimal portfolio

Answer 3

Question 4

Efficient Set

Answer 4

Question 5

Steps to find the optimal investment solution

Assumptions

Answer 5

Question 6

Expected portfolio return (with risk-free asset included)

Answer 6

Question 7

Risk minimization of portfolio when risk-free asset is included

Answer 7

Question 8

Portfolio risk vs return equation

Answer 8

Question 9

What is two-fund separation?

Answer 9

Question 10

What are demand and supply of risky securities?

Answer 10

Question 11

How do we measure the risk of a given stock in this setting?

Answer 11

Question 12

CAPM equation

Answer 12

Question 13

Graphically show Capital Market Line

Answer 13

Question 14

Security Market Line

Answer 14

Question 15

What if we find a stock that does not lie on the SML?

Assume that we have identified a stock that lies above the SML

Answer 15

1) Abnormal or excess positive return
2) Stock is currently under-priced
3) Give the stock higher weight in your portfolio than in the market portfolio

Question 16

Relationship between expected returns and prices

Answer 16

Question 17

Factors other than β that explains excess return

Answer 17

Question 18

2 factor Arbitrage Pricing Theory

Answer 18

Question 19

The Fama French 3 factor model

Answer 19

This model seems to perform better than the CAPM empirically (with the value factor being especially important). Why size and value represent sources of risk that investors care about is not entirely obvious, though.