PORTFOLIO RISK AND RETURN: PART II Flashcards

Question

The tangency point between the capital market line and the efficient frontier represents: A. The risk-free asset B. The optimal risky portfolio (market portfolio) C. The minimum variance portfolio

Answer 1

Correct Answer: B Explanation: The tangency point represents the optimal risky portfolio (market portfolio under homogeneous expectations) that maximizes the Sharpe ratio Option A is incorrect as the risk-free asset is at the y-intercept Option C is incorrect as the minimum variance portfolio is typically not the tangency portfolio

Answer 2

Correct Answer: B Explanation: σM represents the standard deviation (total risk) of the market portfolio in the CML equation Option A describes correlation, which is typically denoted differently Option C is incorrect as the market portfolio's beta is always 1.0 by definition

Answer 3

Correct Answer: A Explanation: Indifference curves represent an investor's utility function, showing combinations of risk and return that provide equal satisfaction Option B describes the efficient frontier, which is the curved line Option C describes the CML, which is the straight line

Answer 4

Correct Answer: B Explanation: Homogeneous expectations means all investors share identical beliefs about security expected returns, risks, and correlations Option A is incorrect as risk tolerance reflects individual preferences, not expectations Option C is incorrect because even with homogeneous expectations, investors may choose different portfolio weights based on their risk preferences

Answer 5

Correct Answer: B Explanation: The optimal portfolio for an investor occurs where their highest indifference curve is tangent to their capital allocation line, maximizing their utility Option A describes the optimal risky portfolio, not the investor's complete optimal portfolio Option C describes the maximum return portfolio, which may not be optimal due to excessive risk

Answer 6

Correct Answer: B Explanation: The CAL is constructed by combining a risk-free asset with a risky portfolio, showing all possible risk-return combinations Option A is incorrect as the CAL specifically includes the risk-free asset Option C is incorrect as risk can only be eliminated by investing entirely in the risk-free asset

Answer 7

Explanation: Individual CALs can use any risky portfolio, while the CML specifically uses the market portfolio as the optimal risky portfolio under homogeneous expectations Option A is incorrect as the risk-free rate is typically the same for all investors Option C is incorrect as both use the same mathematical relationship between risk and return

Answer 8

Correct Answer: B Explanation: Unsystematic risk, also known as unique or firm-specific risk, is the risk associated with individual securities and can be reduced or eliminated through diversification across assets that are not perfectly correlated. This aligns with the concept described in the section. A is incorrect because it describes systematic risk, not unsystematic risk. C is incorrect as it refers to systematic risk, which remains constant and cannot be diversified away.

Answer 9

Correct Answer: B Explanation: Unsystematic risk decreases as more securities are added to a portfolio, and it can be largely eliminated with sufficient diversification (e.g., around 30 securities), as shown in Figure 84.5. A is incorrect because adding securities reduces, rather than increases, unsystematic risk. C is incorrect because unsystematic risk is diversifiable and does not remain constant.

Answer 10

Correct Answer: B Explanation: The section explains that total risk can be broken down into its component parts: total risk = systematic risk + unsystematic risk, providing a clear additive relationship. A is incorrect because it suggests subtraction, which does not align with the concept. C is incorrect because it implies multiplication, which is not the intended relationship.

Answer 11

Correct Answer: B Explanation: Systematic risk, also called market risk or nondiversifiable risk, affects the entire market and cannot be eliminated through diversification, as noted in the section. A and C are incorrect because both unsystematic risk and firm-specific risk can be reduced through diversification.

Answer 12

Correct Answer: A Explanation: The section notes that securities like Ferrari and Harley-Davidson have high systematic risk because their returns are highly correlated with overall market returns, making them sensitive to market changes. B is incorrect as it contradicts the idea of high systematic risk. C is incorrect because high systematic risk implies less influence from firm-specific factors, not low exposure.

Answer 13

Correct Answer: B Explanation: The section states that academic studies indicate it takes about 12 to 18 stocks in a portfolio to achieve approximately 90% of the maximum diversification benefit. A is incorrect as it underestimates the number needed for significant diversification. C is incorrect as 30 securities are cited as achieving near-complete diversification, exceeding the 90% mark.

Answer 14

Correct Answer: B Explanation: As the number of securities approaches 30, the total risk approaches the level of market risk (systematic risk), as unsystematic risk is largely diversified away, per Figure 84.5. A is incorrect because total risk decreases with diversification. C is incorrect because the remaining risk is systematic, not unsystematic.

Answer 15

Correct Answer: B Explanation: In a well-diversified portfolio, unsystematic risk (firm-specific or unique risk) is largely eliminated, leaving market risk (systematic risk) as the primary source, as described in the section. A and C are incorrect because they refer to unsystematic risk, which is diversified away.

Answer 16

Correct Answer: A Explanation: The section indicates that firms like utility companies respond more to firm-specific factors and have very little systematic risk, unlike luxury goods manufacturers or startups. B and C are incorrect because these firms are more exposed to market-wide changes, increasing systematic risk.

Answer 17

Correct Answer: B Explanation: The section states that diversification across imperfectly correlated assets reduces the portfolio’s risk below the weighted average of the risks of individual securities due to the elimination of unsystematic risk. A is incorrect because diversification lowers, not increases, risk. C is incorrect because diversification does affect and reduce risk.

Answer 18

Correct Answer: B Explanation: Systematic risk applies to individual securities and portfolios due to market-wide factors (e.g., economic changes), as outlined in the section. A is incorrect because systematic risk cannot be eliminated by holding a single security. C is incorrect because it describes unsystematic, not systematic, risk.

Answer 19

Correct Answer: B Explanation: The standard deviation of a portfolio decreases with increased diversification until it reaches the level of systematic risk, as depicted in Figure 84.5. A is incorrect because higher diversification reduces, rather than increases, standard deviation. C is incorrect because diversification does impact standard deviation.

Answer 20

Correct Answer: A Explanation: The section mentions that beta, a measure of systematic risk, will be developed later in the curriculum. B is incorrect because alpha measures excess return, not risk. C is incorrect because standard deviation measures total risk, not specifically systematic risk.

Answer 21

Correct Answer: C Explanation: Capital market theory concludes that equilibrium security returns depend on a stock’s or portfolio’s systematic risk, not total risk, as it is the only risk that cannot be diversified away and thus requires compensation. A is incorrect because total risk includes unsystematic risk, which is not compensated. B is incorrect because unsystematic risk can be eliminated through diversification and does not influence equilibrium returns.

Answer 22

Correct Answer: B Explanation: The theory assumes diversification is free (e.g., through low-cost index funds), and since unsystematic risk can be eliminated at no cost, investors are not compensated for bearing it. A is incorrect because the difficulty of measurement is not the reason; it’s the ability to diversify that matters. C is incorrect because unsystematic risk does not significantly impact equilibrium returns when diversified.

Answer 23

Correct Answer: A Explanation: A biotech stock with high unsystematic risk has a lower equilibrium return because its systematic risk (market sensitivity) is low, and only systematic risk is compensated, as per the section. B is incorrect because a stock with high systematic risk would have a higher equilibrium return. C is incorrect as it lacks context about specific risk composition.

Answer 24

Correct Answer: B Explanation: Holding many biotech stocks diversifies away firm-specific (unsystematic) risk, as some stocks may succeed while others fail, reducing portfolio uncertainty, as noted in the section. A is incorrect because diversification reduces, not increases, unsystematic risk. C is incorrect because diversification does impact and reduce unsystematic risk.

Answer 25

Correct Answer: B Explanation: The section assumes diversification is free or very low cost (e.g., via no-load index funds), supporting the idea that unsystematic risk can be eliminated without expense. A is incorrect because the theory assumes low or no cost, not significant investment. C is incorrect because diversification reduces total risk by eliminating unsystematic risk.

Answer 26

Correct Answer: B Explanation: The section explains that the biotech stock’s high total risk is primarily from firm-specific (unsystematic) factors, making systematic risk a small proportion of total risk. A is incorrect because market factors have little impact on this stock. C is incorrect because systematic risk is influenced by the stock’s contribution to market risk.

Answer 27

Correct Answer: B Explanation: Capital market theory implies that expected (equilibrium) returns depend only on systematic risk, as unsystematic risk can be diversified away, affecting asset pricing models. A is incorrect because total risk includes uncompensated unsystematic risk. C is incorrect because diversification impacts risk and thus expected returns indirectly.

Answer 28

Correct Answer: B Explanation: The section notes that a machine tool manufacturer may have greater sensitivity to systematic risk factors (e.g., GDP growth), leading to a higher equilibrium return despite lower total risk. A is incorrect because higher market sensitivity increases, not lowers, returns. C is incorrect because higher unsystematic risk lowers the equilibrium return.

Answer 29

Correct Answer: B Explanation: Systematic risk is measured by a security’s contribution to the risk of a well-diversified portfolio, as it reflects the market-related risk that cannot be diversified away. A is incorrect because standard deviation measures total risk, not just systematic risk. C is incorrect because variance of unsystematic risk is diversifiable and not the focus.

Answer 30

Correct Answer: B Explanation: In a well-diversified portfolio, the expected equilibrium return depends only on the security’s systematic risk, as unsystematic risk is eliminated, per capital market theory. A is incorrect because total risk, including unsystematic risk, does not determine equilibrium returns. C is incorrect because diversification affects the risk profile and thus the return.

Answer 31

Correct Answer: B Explanation: The correct answer is B because return generating models, such as the multifactor and market models, are used to estimate expected returns on risky securities by considering factors like economic conditions or market performance, as outlined in the LOS. A is incorrect because these models provide estimates, not exact calculations, and rely on assumptions rather than guaranteed historical outcomes. C is incorrect as these models do not guarantee returns; they assess risk and potential returns without ensuring a minimum.

Answer 32

Correct Answer: B Explanation: The correct answer is B because beta in the market model measures how sensitive a security’s return is to the overall market portfolio, as defined in the LOS. A is incorrect because beta does not measure total return; it measures sensitivity. C is incorrect as the risk-free rate is a separate baseline, not related to beta.

Answer 33

Correct Answer: B Explanation: The correct answer is B because multifactor models often include macroeconomic factors like GDP growth, inflation, or industry growth to explain security returns, as noted in the LOS. A is incorrect as company management quality is not a standard factor in these models. C is incorrect because individual sentiment is not a formalized factor in multifactor models.

Answer 34

Correct Answer: A Explanation: The correct answer is A because the first factor in the multifactor model often represents the expected excess return on the market, as stated in the LOS. B is incorrect as the first factor does not offset other factors; it contributes to the total return. C is incorrect because the baseline is typically the risk-free rate, not the first factor itself.

Answer 35

Correct Answer: A Explanation: The correct answer is A because excess return in the market model is the return above the risk-free rate, as per the LOS. B is incorrect because it includes all factors beyond the scope of the market model. C is incorrect as excess return is not specifically adjusted for inflation.

Answer 36

Correct Answer: B Explanation: The correct answer is B because the multifactor model is notably associated with Fama and French, who estimated it using factors like market risk and size, as mentioned in the LOS. A is incorrect as the single-index model is a simpler version, not specifically tied to Fama and French. C is incorrect because CAPM is a different framework, though related.

Answer 37

Correct Answer: B Explanation: The correct answer is B because the market model assumes a linear relationship between a security’s excess return and the market portfolio’s excess return, as described in the LOS. A is incorrect as the model relies on this relationship. C is incorrect as the relationship is positive, not inverse.

Answer 38

Correct Answer: A Explanation: The correct answer is A because the intercept in the market model represents the abnormal return on an asset, as per the LOS. B is incorrect because the slope coefficient is beta, not the abnormal return. C is incorrect as the risk-free rate is a baseline, not an abnormal return.

Answer 39

Correct Answer: B Explanation: Return generating models are used to estimate expected returns on risky securities based on specific factors that explain security returns, helping investors understand the sensitivity of returns to various risk factors. Option A is incorrect because these models estimate expected returns, not exact future returns, as future returns are uncertain. Option C is incorrect because while historical data may be used in model estimation, the primary purpose is to estimate expected future returns, not analyze past performance.

Answer 40

Correct Answer: B Explanation: Macroeconomic factors are broad economic variables that affect all securities in the market, such as GDP growth, inflation, and interest rates. Option A is incorrect because company-specific factors are microeconomic, not macroeconomic factors. Option C is incorrect because industry-specific factors are considered sector factors, not macroeconomic factors that affect the entire market.

Answer 41

Correct Answer: B Explanation: βi represents the factor sensitivity or factor loading, which measures how sensitive Asset i's returns are to changes in factor i. Option A is incorrect because E(Factor i) represents the expected value of the factor, not βi. Option C is incorrect because Rf is the risk-free rate, and βi is not a risk-free rate adjustment but rather a sensitivity measure.

Answer 42

Correct Answer: B Explanation: The Fama and French three-factor model includes market return, firm size (small minus big), and book value to market value ratio (high minus low). Option A is incorrect because momentum is not one of the original three factors in the Fama-French model (though it was added later in their four-factor model). Option C is incorrect because interest rates and inflation are macroeconomic factors but not the specific factors in the Fama-French three-factor model.

Answer 43

Correct Answer: C Explanation: The expected excess return attributable to the factor is calculated as β × E(Factor) = 1.2 × 8% = 9.6%. Option A is incorrect because it appears to be 8%/1.2, which is not the correct calculation. Option B is incorrect because it only considers the factor's expected value without accounting for the stock's sensitivity to that factor.

Answer 44

Correct Answer: B Explanation: Statistical factors are identified through data mining techniques such as factor analysis or principal component analysis applied to historical return data. Option A is incorrect because economic theory and fundamental analysis are used to identify macroeconomic and fundamental factors, not statistical factors. Option C is incorrect because survey research is not a method used to identify statistical factors in return generating models.

Answer 45

Correct Answer: B Explanation: The key difference is that single-factor models use only one risk factor to explain returns, while multifactor models use multiple risk factors. Option A is incorrect because single-factor models can use any single risk factor, not necessarily just market return. Option C is incorrect because multifactor models are generally considered more comprehensive and potentially more accurate as they account for multiple sources of risk

Answer 46

Correct Answer: B Explanation: The market model uses the excess return on the market portfolio as its single risk factor. Option A is incorrect because inflation rate is a macroeconomic factor but not the specific factor used in the market model. Option C is incorrect because GDP growth rate is also a macroeconomic factor but not the factor used in the market model.

Answer 47

Correct Answer: B Explanation: Factor sensitivity (beta) measures how much an asset's return responds to changes in the factor - it's a measure of sensitivity or responsiveness. Option A is incorrect because higher sensitivity doesn't always mean higher expected returns; it depends on the expected value of the factor and whether the sensitivity is positive or negative. Option C is incorrect because factor sensitivity can be positive, negative, or zero depending on how the asset responds to the factor.

Answer 48

Correct Answer: B Explanation: Beta measures systematic risk - the sensitivity of an asset's returns to market movements. It quantifies how much an asset's returns move relative to the overall market. Option A is incorrect because beta does not measure total risk; it only captures the systematic (market-related) portion of risk. Option C is incorrect because beta specifically measures systematic risk, not unsystematic risk, and unsystematic risk is what can be diversified away.

Answer 49

Correct Answer: A Explanation: The correct market model equation is Ri = αi + βi × Rm + εi, where Ri is the asset return, αi is the intercept (alpha), βi is beta, Rm is the market return, and εi is the error term. Option B incorrectly places beta as the intercept and alpha as the slope coefficient. Option C incorrectly positions the variables and would not properly capture the relationship between asset and market returns.

Answer 50

Correct Answer: A Explanation: Covariance measures how two variables move together - positive covariance indicates they tend to move in the same direction, while negative covariance indicates they move in opposite directions. Option B is incorrect because total variability is measured by variance, not covariance. Option C is incorrect because the risk-free rate is a separate concept unrelated to covariance.

Answer 51

Correct Answer: C Explanation: Beta is calculated as the covariance between the asset and market returns divided by the variance of the market returns: βi = Cov(Ri, Rm) / Var(Rm). Option A is incorrect because it multiplies rather than divides, which would not give the correct sensitivity measure. Option B is incorrect because it inverts the correct formula, which would give the reciprocal of beta.

Answer 52

Correct Answer: B Explanation: A beta of 1.0 means the asset has the same systematic risk as the market and tends to move in the same direction and magnitude as the market. Option A is incorrect because a beta of 1.0 indicates perfect correlation with market movements, not no correlation. Option C is incorrect because a beta of 2.0 (not 1.0) would indicate the asset is twice as volatile as the market.

Answer 53

Correct Answer: B Explanation: A beta of 0.5 indicates the asset is less volatile than the market, moving approximately half as much as the market in the same direction. Option A is incorrect because a positive beta (0.5) means the asset moves in the same direction as the market, not opposite. Option C is incorrect because a beta of 0.5 indicates lower volatility than the market, not higher.

Answer 54

Correct Answer: B Explanation: In the regression of asset returns against market returns, the slope coefficient directly represents beta - the sensitivity of the asset to market movements (the security characteristic line). Option A is incorrect because alpha is the intercept of the regression line, not the slope. Option C is incorrect because R-squared measures the goodness of fit of the regression, not the slope.

Answer 55

Correct Answer: B Explanation: Alpha represents the intercept of the regression line and indicates the portion of returns that is not explained by market movements - the asset's excess return above what would be predicted by its beta. Option A is incorrect because systematic risk is measured by beta, not alpha. Option C is incorrect because correlation is a separate statistical measure, not the intercept.

Answer 56

Correct Answer: B Explanation: The security characteristic line is the graphical representation of the regression between an asset's returns and the market returns, with beta as the slope. Option A is incorrect because the security characteristic line relates asset returns to market returns, not the risk-free rate. Option C is incorrect because the line shows systematic risk relationship, not total risk.

Answer 57

Correct Answer: A Explanation: A negative beta indicates that the asset tends to move in the opposite direction of the market - when the market goes up, the asset tends to go down, and vice versa. Option B is incorrect because a negative beta still indicates a relationship with the market, just an inverse one. Option C is incorrect because the sign of beta indicates direction, not the magnitude of volatility.

Answer 58

Correct Answer: B Explanation: Beta is typically estimated using regression analysis of historical returns, where asset returns are regressed against market returns to find the slope coefficient (beta). Option A is incorrect because while theory guides the approach, practical estimation relies on empirical data analysis. Option C is incorrect because fundamental analysis, while useful for other purposes, is not the primary method for beta estimation.

Answer 59

Correct Answer: B Explanation: The SML shows the linear relationship between expected return and systematic risk (beta) for all securities, as systematic risk is the only risk that matters for pricing individual assets Option A is incorrect because the SML relates to systematic risk, not total risk Option C is incorrect because unsystematic risk can be diversified away and is not priced in the market

Answer 60

Correct Answer: B Explanation: The term [E(RMkt) - Rf] represents the market risk premium, which is the excess return investors require for holding the market portfolio instead of risk-free assets Option A is incorrect because Rf alone represents the risk-free rate Option C is incorrect because βi represents the security's beta coefficient

Answer 61

Correct Answer: B Explanation: A beta of 1.0 indicates the security moves exactly with the market, so its expected return should equal the market return Option A is incorrect because a beta of 1.0 means the security has market-level risk, not zero risk Option C is incorrect because a beta greater than 1.0 would be needed for returns greater than the market return

Answer 62

Correct Answer: C Explanation: The CAPM assumes homogeneous expectations, meaning all investors have the same expectations about expected returns, standard deviations, and correlations Option A is incorrect because risk aversion is indeed an assumption of CAPM Option B is incorrect because frictionless markets (no transaction costs) is an assumption of CAPM

Answer 63

Correct Answer: B Explanation: Beta is defined as the standardized covariance between the asset's returns and market returns (Covi,mkt/σ²mkt) Option A is incorrect because standard deviation measures total risk, not the relationship with the market Option C is incorrect because correlation measures the strength of linear relationship but is not the standardized covariance used in CAPM

Answer 64

Correct Answer: B Explanation: The CAPM assumes all investors have the same one-period investment horizon Option A is incorrect because investors can have different risk tolerances under CAPM assumptions Option C is incorrect because while investors are utility-maximizing, they don't need identical utility functions

Answer 65

Correct Answer: B Explanation: CAPM assumes competitive markets where no single investor can influence prices, so all investors are price takers Option A is incorrect because this would violate the competitive market assumption Option C is incorrect because even institutional investors cannot influence prices under CAPM assumptions

Answer 66

Correct Answer: B Explanation: CAPM assumes all investments are infinitely divisible, meaning investors can buy any fractional amount Option A is incorrect because "finitely divisible" would impose limitations on investment amounts Option C is incorrect because this would prevent optimal portfolio construction

Answer 67

Correct Answer: B Explanation: The risk-free asset has zero systematic risk, which means its beta equals 0.0 Option A is incorrect because a beta of 1.0 would indicate market-level systematic risk Option C is incorrect because the risk-free asset's beta is constant at zero

Answer 68

Correct Answer: C Explanation: The theoretical market portfolio includes all risky assets in the economy, weighted by their market values Option A is incorrect because the market portfolio is not limited to domestic stocks Option B is incorrect because the market portfolio contains only risky assets, not risk-free assets

Answer 69

Correct Answer: B Explanation: Beta specifically measures how much a security's returns change in response to a 1% change in market returns (sensitivity) Option A is incorrect because correlation measures the strength of linear relationship, not sensitivity Option C is incorrect because beta measures only systematic risk, not total risk

Answer 70

Correct Answer: A Explanation: CAPM assumes frictionless markets where investors can both borrow and lend unlimited amounts at the same risk-free rate Option B is incorrect because borrowing is allowed in CAPM assumptions Option C is incorrect because different rates would create market friction, violating CAPM assumptions

Answer 71

Correct Answer: B Explanation: CAPM states that only systematic risk (beta) is priced because unsystematic risk can be diversified away Option A is incorrect because total risk includes unsystematic risk, which is not priced Option C is incorrect because unsystematic risk does not affect expected return in CAPM

Answer 72

Correct Answer: A Explanation: A is correct. The CML shows the risk-return relationship for efficient portfolios only, using total risk (standard deviation) on the x-axis. B is incorrect. That describes the Security Market Line (SML), which uses beta (systematic risk), not total risk. C is incorrect. The CML does not plot individual securities; it only applies to efficient portfolios.

Answer 73

Correct Answer: B Explanation: B is correct. The SML relates expected return to beta, which is a measure of systematic risk. A is incorrect. Total risk is used in the CML, not the SML. C is incorrect. Unsystematic risk is diversifiable and not priced in the CAPM model.

Answer 74

Correct Answer: C Explanation: C is correct. CAPM assumes all investors share the same expectations regarding risk, return, and correlations. A is incorrect. CAPM assumes investors are risk-averse and prefer higher returns for the same level of risk. B is incorrect. That contradicts the homogeneous expectations assumption in CAPM.

Answer 75

Correct Answer: C Explanation: C is correct. A stock with β = 1.5 has higher systematic risk and therefore higher expected return than the market (β = 1). A is incorrect. Higher beta implies higher return, not lower. B is incorrect. If fairly priced, the stock lies on, not below, the SML.

Answer 76

Correct Answer: C Explanation: C is correct. Assets below the SML offer lower returns for their level of risk—thus, they are overvalued. A is incorrect. A fairly priced asset lies on the SML. B is incorrect. Assets above the SML offer higher return per unit of risk.

Answer 77

Correct Answer: C Explanation: C is correct. Only combinations of the market portfolio and the risk-free asset lie on the CML. A is incorrect. Individual securities and non-optimal combinations do not lie on the CML. B is incorrect. Inefficient portfolios do not lie on the CML.

Answer 78

Correct Answer: C Explanation: C is correct. The slope of the CML is the Sharpe Ratio: excess return per unit of total risk. A is incorrect. Beta is used in the SML, not the CML. B is incorrect. The x-axis shows total risk, but the slope itself is the Sharpe Ratio.

Answer 79

Correct Answer: C Explanation: C is correct. CAPM assumes no taxes, no transaction costs, and rational investors. A is incorrect. CAPM assumes investors borrow and lend at the same risk-free rate. B is incorrect. Under homogeneous expectations, investors share the same efficient frontier.

Answer 80

Correct Answer: B Explanation: B is correct. Beta of 0 means no correlation with the market—its returns are unrelated to market returns. A is incorrect. It earns the risk-free rate, not the market return. C is incorrect. Total risk may be high or low, but it’s not related to beta directly.

Answer 81

Correct Answer: B Explanation: B is correct. CAPM only rewards investors for bearing systematic (market) risk. A is incorrect. Total risk is not rewarded unless it's systematic. C is incorrect. Only efficient portfolios lie on the CML. All assets lie on the SML.

Answer 82

Correct Answer: C Explanation: C is correct. The market portfolio lies at the tangency point between the CML and the efficient frontier under CAPM. A is incorrect. The risk-free asset lies on the y-axis, not on the efficient frontier. B is incorrect. The indifference curve touches the CML where optimal utility is achieved, not necessarily at the tangency with the fronti

Answer 83

Correct Answer: B Explanation: B is correct. A beta of 1 means the asset should earn the same return as the market portfolio. A is incorrect. Assets with beta = 0 earn the risk-free rate. C is incorrect. A beta > 1 implies a return greater than the market, not a beta = 1.

Answer 84

Correct Answer: A Explanation: A is correct. Total risk includes diversifiable risk, which CAPM assumes is not priced. B is incorrect. Beta (systematic risk) is a key determinant of return in CAPM. C is incorrect. The risk-free rate is part of the CAPM formula.

Answer 85

Correct Answer: B Explanation: B is correct. Portfolios inside the efficient frontier are inefficient—they provide lower return for a given level of risk. A is incorrect. Only portfolios on the efficient frontier are efficient. C is incorrect. Unsystematic is a type of risk, not a descriptor for portfolios.

Answer 86

Correct Answer: B Explanation: B is correct. Portfolios on the CML provide the highest Sharpe Ratio and dominate inefficient portfolios. **A is partially true but not precise—CML portfolios offer better return-to-risk tradeoff, not just lower risk. C is incorrect. Portfolios inside the efficient frontier are not perfectly diversified.

Answer 87

Correct Answer: B Explanation: B is correct. An increase in the risk-free rate decreases the slope of the CML (Sharpe Ratio), flattening the line. A is incorrect. A higher risk-free rate with unchanged market return reduces the excess return, flattening the slope. C is incorrect. The CML is affected by changes in the risk-free rate.

Answer 88

Correct Answer: B Explanation: B is correct. Homogeneous expectations are a unique assumption of CAPM. A and C are assumptions common to general portfolio theory, not just CAPM.

Answer 89

Correct Answer: C Explanation: C is correct. Assets above the SML offer higher returns for their level of systematic risk, indicating they are underpriced. A is incorrect. Overpriced assets lie below the SML. B is incorrect. Fairly priced assets lie on the SML.

Answer 90

Correct Answer: B Explanation: B is correct. CAPM assumes only systematic risk is rewarded because diversifiable risk can be eliminated. A is incorrect. Total risk can be measured as standard deviation. C is incorrect. Total risk does not imply perfect correlation.

Answer 91

Correct Answer: B Explanation: B is correct. Risk-averse investors stay close to the risk-free asset on the CML. A is incorrect. High σ implies high risk, not suitable for risk-averse investors. C is incorrect. High-beta assets imply more systematic risk.

Answer 92

Correct Answer: B Explanation: B is correct. Borrowing at the risk-free rate to invest more in the market pushes the portfolio above the market on the CML. A is incorrect. Leveraged portfolios lie on, not inside, the CML. C is incorrect. Fairly priced assets (including leveraged portfolios) lie on the SML.

Answer 93

Correct Answer: C Explanation: C is correct. The market portfolio is the tangency point of the CML and has β = 1 on the SML. A is incorrect. Investors should hold efficient portfolios on the frontier or CML. B is incorrect. The market portfolio is efficient under CAPM.

Answer 94

Correct Answer: B Explanation: B is correct. A stock with low beta may have high unsystematic (firm-specific) risk. A is incorrect. High firm-specific risk implies they are not perfectly diversified. C is incorrect. Negative correlation would lead to a negative beta, not low total risk.

Answer 95

Correct Answer: B Explanation: B is correct. With β < 1, the expected return is less than the market return. A is incorrect. It only lies above the SML if it's underpriced. C is incorrect. Beta of 0.5 means it is affected by the market, but less than proportionally.

Answer 96

Correct Answer: C Explanation: C is correct. The Sharpe Ratio measures excess return per unit of standard deviation (total risk). A is incorrect. That describes the Treynor Ratio, not Sharpe. B is incomplete. It’s not just a measure of risk—it incorporates return as well.

Answer 97

Correct Answer: A Explanation: Required Return = 5% + 1.2(13% - 5%) = 5% + 9.6% = 14.6% Expected return = 11%, which is less than required, so the stock is overvalued and plots below the SML. B is incorrect: the return is too low to justify its risk. C is incorrect: it does not meet the required return.

Answer 98

Correct Answer: C Explanation: C is correct. If a stock offers more return than required for its beta risk, it's undervalued and plots above the SML. A is incorrect. That would indicate a deeply unattractive or distressed asset. B is incorrect. Equal returns indicate fair pricing, not undervaluation.

Answer 99

Correct Answer: C Explanation: Required Return = 6% + 0.8(12% - 6%) = 10.8% Expected return = 10.8% → Matches required return → Stock lies on the SML → Properly priced A is incorrect: expected does not fall below required. B is incorrect: no excess return over what's required.

PORTFOLIO RISK AND RETURN: PART II Flashcards

(124 cards)