Portfolio Theory and CAPM

Question 1

Tangency portfoliosptimal risky asset portfolio

Answer 1

this is the risky asset

portfolio tangent to the capital allocation line (CAL).

Question 2

the optimal risky portfolio will have the?

Answer 2

highest Sharpe ratio

Highest Sharpe ratio = slope of the CAL that is tangent to the efficient frontier

Question 3

Optimal combined portfolio

Answer 3

his is the portfolio where an indifference curve is tangent to the CAL.

Question 4

The capital market line (CML)

Answer 4

If every investor chooses the same risky asset portfolio, then the tangent portfolio must be the market portfolio that includes all available risky assets (i.e. equity, bonds, real estate etc).
– The capital allocation line (CAL) is now called the capital market line (CML)

Question 5

The Capital Asset Pricing Model (CAPM) provides

Answer 5

a prediction of the relationship between the expected return on an asset and its risk

Question 6

CAPM makes what assumptions

Answer 6

Markets are frictionless so trading has no impact on market
prices (e.g. prices will not change as the market is liquid).
– All investors have quadratic utility and are rational. In other
words all investors are mean-variance optimisers.
nvestors can differ in their degree of risk aversion.
– We consider a two period economy (e.g. now and later.)
– There are no informational asymmetries as investors have access to all the information

Question 7

‘market risk’ aka ‘systematic risk’

Answer 7

Only remains in well-diversified portfolios. That is why ‘market risk’ is also called ‘non- diversifiable risk’.

Question 8

‘stock-specific risk’ aka ‘idiosyncratic risk’

Answer 8

can be eliminated due to diversification (cancellation of asset-specific fluctuations). It is also called ‘diversifiable risk’

Question 9

What is Beta?

Answer 9

Beta measures the sensitivity of the asset’s returns to

market-wide movements.

Question 10

The goal of the CAPM is:

Answer 10

– identify the relevant risk that investors care about, and
– establish a fair rate of return for an asset given its (systematic) risk. Simply put, risk premium = amount of the relevant risk x ‘price’ or ‘premium’ per unit of the risk

Question 11

Implementing modern portfolio theory (MPT) is difficult in a world of many assets

Answer 11

We need to know the expected return for each individual asset and the covariances between all the returns of all the individual assets.
– This is a monumental estimation task; If there are n assets then we need to make n(n+1) estimates.