Short Answer Questions

Question 1

What is the CML?

Answer 1

• a line representing expected returns of efficient portfolios in relation to their total risk

Question 2

What is the SML?

Answer 2

• security market line
• a line representing the linear relationship between expected returns of any risky assets/portfolios and their systematic risk
• given by the equation: E(Ri) = rf + βi

Question 3

Briefly explain how the use of a single company cost of capital to evaluate all projects might lead to erroneous decisions

Answer 3

If the firm is considering projects with differing risk characteristics, the firm will reject good low-risk projects and accept high-risk projects. Low-risk projects should be discounted at a lower rate and high-risk projects at a higher discount rate to account for differing risks.

Question 4

Explain the term SMB

Answer 4

SMB is an acronym for Small-minus-Big. It is the difference in returns between a portfolio of small firms and a portfolio of big firms. SMB stands for the market required excess return associated with the risk of investing in small firms (compared to big firms)

Question 5

Explain the HML

Answer 5

HML is an acronym for High-minus-Low. It is the difference in returns between a portfolio of high BE/ME (value) firms and a portfolio of low BE/ME (growth) firms. HML measures the market required excess return associated with the risk of investing in value firms (compared with growth firms)

Question 6

Briefly explain the CAPM

Answer 6

• The CAPM is an equilibrium model, in a competitive market, that states that the expected return of any risky security/portfolio is a linear function of its systematic risk, measured by its beta.
• provide equation
• explain each variableE

Question 7

Explain beta

Answer 7

• a measure of a security/portfolio’s sensitivity to market movements, specifically to changes in the value of a benchmark index.

Question 8

What is an indifference curve and why is indifference curve important in portfolio theory?

Answer 8

• Indifference curve is the collection of portfolios that gives an investor the same level of utility.
• The shape of the indifference curves of an individual specifies the trade-offs they are willing to make between expected return and risk.
• Indifference curves are derived from their personal utility function. These indifference curves are important because they are used in conjunction with the efficient frontier to determine the efficient portfolio that is the most suitable for an individual investor.
• Given the efficient frontier, indifference curves indicate which portfolio is preferred for the given investor. Notably, because indifference curves differ across individuals, one should expect different investors to select different portfolios on the efficient frontier.

Question 9

What is convexity?

Answer 9

• convexity measures the curvature of the price-yield curve at a particular yield level