Question 1

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

This statement is true. The efficient frontier represents the set of portfolios that offer the highest expected return for a given level of risk. Any portfolio that is above the efficient frontier is not efficient and can be improved upon. However, it is not possible to earn a return that is above the efficient frontier without taking additional risk, unless there is a risk-free asset or an uncorrelated asset available to invest in.

Question 2

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

Accepted Answer

The Sharpe ratio measures the excess return of a portfolio compared to the risk-free rate per unit of volatility. A higher Sharpe ratio indicates a better risk-adjusted return, which is desirable for investors. Therefore, all else equal, investors prefer to choose portfolios with higher Sharpe ratios.

Question 3

Underpriced stocks will plot above the security market line.

Accepted Answer

This is because underpriced stocks have a higher expected rate of return than their required rate of return, meaning they offer more return for the given level of risk. As a result, they will plot above the security market line, which represents the relationship between risk and expected return for a given level of risk.

Question 4

Briefly explain the term risk-free rate of interest.

Accepted Answer

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

Question 5

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

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the market portfolio is a tangency portfolio as it is the portfolio that maximizes expected returns for a given level of risk. The market portfolio consists of all investable assets in the market, and investors can construct portfolios that lie on the efficient frontier by combining the market portfolio with a risk-free asset. The tangency portfolio is where the efficient frontier and Capital Market Line (CML) intersect, representing the optimal portfolio for any given level of risk.

Question 6

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

Accepted Answer

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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

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 9

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

Accepted Answer

Beta measures the volatility of an asset compared to the market. Since U.S. Treasury bills are considered to have no credit risk and are backed by the government, they are seen as a risk-free asset and have a beta equal to zero.

Question 10

Most investors dislike uncertainty.

Accepted Answer

Uncertainty can pose risks and make it difficult for investors to make informed decisions, leading to a preference for stability and predictability.

Question 11

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

Accepted Answer

Risk-free U.S. Treasury bills have no systematic risk, and therefore have a beta of zero.

Question 12

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 as an investment alternative is likely to diversify the portfolio and reduce overall risk, thus improving the risk-return trade-off and expanding the efficient frontier.

Question 13

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

Accepted Answer

Many tests of the CAPM have produced mixed results, and some have even contradicted the theory. While it may provide some explanation for stock returns, it is not a universally accepted or proven model. Additionally, the CAPM has been criticized for oversimplifying the complexities of the stock market and for relying too heavily on assumptions that may not be accurate in practice.

Question 14

Explain the term efficient portfolio.

Accepted Answer

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

Question 15

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

Investors typically prefer portfolios with higher expected return and lower standard deviation, which appear towards the top-left portion of the diagram.

Question 16

Overpriced stocks will plot above the security market line.

Accepted Answer

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

Question 17

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 18

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

Accepted Answer

Both the CAPM and APT assume that unique risk, also known as idiosyncratic risk or company-specific risk, can be diversified away and therefore does not affect expected returns. Only systematic risk, which cannot be diversified away, is considered in determining expected returns in both models.

Question 19

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 20

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 the fluctuations in the market and is generally considered to be a constant rate of return. Therefore, it is not correlated with the return on any common stock, which can be influenced by market movements and other factors. The correlation between these two types of assets is considered to be zero.

Quiz 8: Portfolio Theory and the Capital Asset Pricing Model