Week 3 Flashcards
Markets would be inefficient if irrational investors …. and actions of arbitragers were …. .
Markets would be inefficient if irrational investors existed and actions of arbitragers were limited.
Consider a world in which the assumptions of the portfolio theory hold.
Regarding the securities A and B, the following probability distributions, with the probabilities for three possible states of the world and the corresponding returns, is given:
Probability Return A Return B
0.2 2% 8%
0.6 4% 6%
0.2 6% 4%
Which of the following statements is true?
A) The correlation coefficient between the returns of A and B is zero.
B) The variance of the return of A is negative.
C) The risk of A (measured as the standard deviation of the return) is smaller than that of B.
D) The covariance between the returns of A and B is negative.
The covariance between the returns of A and B is negative.
Explanation:
A “The correlation coefficient between the returns of A and B is zero.” - Incorrect. A and B are not independent. See Answer D.
B “The variance of the return of A is negative.” - Incorrect. The variance can never be negative.
C “The risk of A (measured as the standard deviation of the return) is smaller than that of B.” - Incorrect. The variance is the same. You can verify this, or just observe that A and B have the same deviations in magnitude from their respective means.
D “The covariance between the returns of A and B is negative.” - Correct. If A goes up, B goes down, and vice versa, so the covariance must be negative.
Suppose two portfolios have the same average return and the same standard deviation of returns, but portfolio A has a higher beta than portfolio B. According to the Sharpe measure, the performance of portfolio A..
is the same as the performance of portfolio B.
The Sharpe Ratio is a measure of average portfolio returns (in excess of the risk-free return) per unit of total risk (as measured by standard deviation). Beta is important for the Treynor ratio, but not for the Sharpe ratio.
Your opinion is that CSCO has an expected rate of return of 0.13. It has a beta of 1.3. The risk-free rate is 0.04 and the market expected rate of return is 0.115.
According to the Capital Asset Pricing Model, this security is
overpriced.
13% - (4% + 1.3(11.5% - 4%)) = -0.75%
The security is generating a negative alpha. Therefore, the security is overpriced.
The Jensen portfolio evaluation measure:
is an absolute measure of return over and above that predicted by the CAPM.
Jensen’s alpha is the average return on the portfolio over and above that predicted by the CAPM, given the portfolio’s beta and the average market return.
