Unit 1: Part 2- Further Portfolio Theory & Capital Asset Pricing Model (CAPM)

Question 1

What is an efficient portfolio?

Answer 1

An efficient portfolio provides the highest expected return for a given level of risk & provides the least risk for a given level of expected return

Question 2

Who develops the construction of diversification?

Answer 2

Harry Markowitz (1952) develops the practice of diversification

Question 3

What does it mean if the coefficient correlation is +1 and -1?

Answer 3

Maximum reduction in risk is possible if correlation coefficient is -1 & there is no risk reduction when correlation coefficient is equal to 1 (this generally gives a straight line) (Zero diversification at +1, maximum diversification at -1)

Question 4

What are the 5 assumptions of the Markowitz (1952) framework? (efficient frontier)

Answer 4

investors prefer more consumption not less, investors are rational, investors are risk averse, risk of a portfolio is based on the variability of its return and model examines a single period of investor

Question 5

Where is the best place in the efficient frontier for an investor to be?

Answer 5

the top LHS because here you are lowering your level of risk but maximising your level of return (you want to shift from the right to the left)

Question 6

How are 2 returns in a portfolio correlated?

Answer 6

The returns on 2 securities are negatively correlated. When one goes down, the other goes up.

Question 7

What is the black line that goes through the efficient frontier?

Answer 7

The black straight line is known as the Capital Market line and is measured using the Sharpe ratio

Question 8

What is the Sharpe Ratio?

Answer 8

The Sharpe ratio measures the level of reward per unit of risk in a portfolio & is said to provide a summary to investors about the performance of a portfolio, adjusting for its risk (the larger the ratio, the better)

Question 9

What is the lending & borrowing portion of the Capital Market Line?

Answer 9

The lending portion of the line represents when investors lend money to the government and receive government bonds in return. Beyond point M, is where investors borrow at the risk free rate (borrowing portion). This is only achievable if the investor borrows at the risk free rate and invests in the market portfolio. Very risky.

Question 10

What do risk averse & risk seeking investors do?

Answer 10

Risk averse investor would invest in a combination of the risk free asset and the market portfolio (choose a well-diversified portfolio), whereas a risk seeking investor would invest in a combination of the market portfolio and borrowing at the risk free rate

Question 11

What are the key assumptions for investors for efficient portfolio?

Answer 11

investors maximise utility functions that depend on the expected return & s.d. of returns of portfolios, and while individual utility functions vary, all investors agree on the distribution of expected returns

Question 12

What are the key assumptions for the market for efficient portfolio?

Answer 12

there are no transaction costs or taxes to impede the operation of arbitrage processes and information is costless & as a result, all investors are perfectly informed, & not surprisingly have identical expectations

Question 13

What are the 6 CAPM assumptions?

Answer 13

1) Investors make decisions based solely on risk-return assessments, 2) The purchase and sale transactions can be undertaken in infinitely divi­sible units, 3) Investors can sell short any number of shares without limit, 4) There is perfect competition and no single investor can influence prices, with no transactions costs, involved, 5) Personal income taxation is assumed to be zero & 6) Investors can borrow/lend, the desired amount at riskless rates

Question 14

What gives rise to the single index model factor?

Answer 14

We consider the way the portfolio has reacted in the past and assume a similar reaction for the future. We can essentially plot the expected return of the portfolio against the expected return in the market and this gives rise to single index model factor

Question 15

What is Beta?

Answer 15

A measure of market risk (The higher the beta, the higher the expected return)

Question 16

What is the Security Market Line?

Answer 16

The security market line says that the return on an asset is equal to the risk free rate plus Beta multiplied by market risk premium. The greater the risk, the greater the market risk premium and hopefully the greater the return.

Question 17

What does the CAPM say about the returns in a portfolio?

Answer 17

The Capital Asset Pricing Model says that in a portfolio, the returns are proportional to the returns in the market index.

Question 18

What returns does the CAPM only consider?

Answer 18

The CAPM only considers returns in excess of those that can be observed by using the risk free rate

Question 19

Where do we expect all points to lie under CAPM?

Answer 19

Under the CAPM, we would expect all the points to lie on the security market line. f it doesn’t lie on the SML, then the expected return is not equivalent to its risk & is over or under priced

Question 20

What happens if an asset is underpriced under CAPM?

Answer 20

If an asset is underpriced, there would an increase in demand in the market. Then if demand increases, this would drive up the price. This would then lower the expected return until the point lies on the Sml. Therefore, this would provide a correction for the underpriced asset. The opposite would occur if the asset is overpriced as many investors would sell their asset, resulting in a reduction in price etc.