Question 1

The correlation between the return on a risk-free asset and the return on any common stock will equal zero.

Accepted Answer

The return on a risk-free asset is not affected by any factors affecting the return on common stock, hence there is no correlation between the two.

Question 2

The arbitrage pricing theory (APT)implies that the market portfolio is efficient.

Accepted Answer

The APT suggests that an asset's return can be explained by several factors rather than just one, and that mispricings based on these factors can be exploited for profit. It does not necessarily imply that the market portfolio is efficient, as there may still be opportunities for profitable trades based on these factors.

Question 3

In theory, the CAPM requires that the market portfolio consist of only common stocks.

Accepted Answer

The Capital Asset Pricing Model (CAPM) posits that the market portfolio should include all assets in the market, including stocks, bonds, real estate, and even personal income, as long as they are marketable and have value, not just common stocks.

Question 4

Risk-free U.S. Treasury bills have a beta greater than zero.

Accepted Answer

U.S. Treasury bills are considered to be risk-free, meaning they are not subject to market risk. As a result, their beta is zero, not greater than zero.

Question 5

Risk-free U.S. Treasury bills have a beta of zero.

Accepted Answer

According to the Capital Asset Pricing Model, the beta of an asset measures its volatility in relation to the market. Since Treasury bills are considered a risk-free asset with a fixed interest rate, they do not fluctuate in value with changes in the market, and hence have a beta of zero.

Question 6

Briefly explain the term risk-free rate of interest.

Accepted Answer

The answer of Briefly explain the term risk-free rate of...

Question 7

Overpriced stocks will plot below the security market line.

Accepted Answer

The security market line represents the expected return of a stock based on its beta and the market risk premium. Stocks that are overpriced will have a lower expected return than what is justified by their beta and risk, causing them to plot below the security market line.

Question 8

Both the CAPM and the APT stress that unique risk does not affect expected return.

Accepted Answer

Both the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) assume that investors can diversify away unique (idiosyncratic) risk, and therefore, only systematic risk affects expected returns.

Question 9

Most investors dislike uncertainty.

Accepted Answer

Uncertainty creates risk and can make it difficult for investors to make informed decisions about their investments. Investors generally prefer a level of predictability and stability in the market.

Question 10

It is not possible to earn a return that is above the efficient frontier of common stocks without the existence of a risk-free asset or some other asset that is uncorrelated with your portfolio assets.

Accepted Answer

The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Without a risk-free asset or an uncorrelated asset, it is not possible to achieve a return that is higher than the efficient frontier as it represents the best possible combination of risk and return given the available assets.

Question 11

Underpriced stocks will plot above the security market line.

Accepted Answer

Underpriced stocks have returns that are greater than their required return based on the Capital Asset Pricing Model (CAPM). This means that they will plot above the security market line, which represents the expected return for a given level of risk according to the CAPM.

Question 12

Underpriced stocks will plot below the security market line.

Accepted Answer

Underpriced stocks will plot above the security market line because they offer higher returns for a given level of risk than what the market typically offers, indicating they are a better value.

Question 13

Overpriced stocks will plot above the security market line.

Accepted Answer

The answer of Overpriced stocks will plot above the security...

Question 14

According to the CAPM, the market portfolio is a tangency portfolio.

Accepted Answer

According to the CAPM, the market portfolio is the portfolio that includes all available securities and has the highest possible Sharpe ratio. This portfolio is located at the point of tangency between the Capital Market Line (CML) and the efficient frontier of risky assets. Therefore, the market portfolio is a tangency portfolio in the context of the CAPM.

Question 15

All else equal, investors prefer to choose from portfolios having higher Sharpe ratios.

Accepted Answer

The Sharpe ratio is a measure of risk-adjusted return, where a higher ratio indicates greater return per unit of risk. Therefore, all else equal, investors would prefer portfolios with higher Sharpe ratios as it indicates a better risk-return trade-off.

Question 16

Briefly explain the effect of introducing borrowing and lending at the risk-free rate on the efficient portfolios.

Accepted Answer

The answer of Briefly explain the effect of introducing borrowing...

Question 17

Explain the term efficient portfolio.

Accepted Answer

The answer of Explain the term efficient portfolio....

Question 18

Almost all tests of the CAPM have confirmed that it explains stock returns, especially for high-beta stocks.

Accepted Answer

While the CAPM is a widely accepted theory, empirical tests have produced mixed results and there is no consensus on whether it fully explains stock returns. Some studies have found support for the CAPM, while others have rejected it or found that it only partially explains returns. Additionally, the idea that the CAPM works better for high-beta stocks is a controversial topic among researchers.

Question 19

In addition to common stocks, the addition of real estate (as an investment alternative)will likely expand the efficient frontier to a better risk-return trade-off.

Accepted Answer

Adding real estate to a portfolio can potentially lower the risk and increase the return, which expands the efficient frontier and creates a better risk-return trade-off.

Question 20

On an expected return versus standard deviation diagram (with expected return on the vertical axis), most investors prefer portfolios that appear more towards the top and the left.

Accepted Answer

This is because portfolios that appear more towards the top and the left have higher expected returns and lower standard deviation, indicating a better risk-return trade-off.

Quiz 8: Portfolio Theory and the Capital Asset Pricing Model