Reading 68: LOS e ～ Q1- 5

1．According to the capital asset pricing model (CAPM), if the expected return on an asset is too high given its beta, investors will:

A)   sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

B)   buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

C)   sell the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

D)   buy the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

The correct answer was B)

The CAPM is an equilibrium model: its predictions result from market forces acting to return the market to equilibrium. If the expected return on an asset is temporarily too high given its beta according to the SML (which means the market price is too low), investors will buy the stock until the price rises to the point where the expected return is again equal to that predicted by the SML.

2．Which of the following is NOT a prediction of the capital asset pricing model (CAPM)?

A)   All investors hold an equally weighted market portfolio of all assets.

B)   All investors identify the same risky tangency portfolio and combine it with the risk-free asset to create their own optimal portfolios.

C)   The expected return and every asset i is described by: E(R_i) = R_F + β_i[E(R_M) -R_F] where R_F is the risk-free rate, β_i is the beta of asset i, and E(R_M) is the expected return on the market portfolio.

D)   The market price of risk is the slope of the capital market line.

The correct answer was A)     

The CAPM predicts that all investors hold the market portfolio - a portfolio in which each asset is held in proportion to its market value. This portfolio is value-weighted, not equally weighted. The capital allocation line is then the capital market line (CML) and the market price of risk is the slope of the CML. The security market line (SML) describes the relationship between asset risk and expected return, where risk is measured by beta.

3．Which of the following is NOT an assumption necessary to derive the capital asset pricing model?

A)   Investors only need to know expected returns, variances, and covariances in order create optimal portfolios.

B)   Investors are price takers whose buy and sell decisions don't affect asset prices.

C)   Investors can borrow and lend at the risk-free rate, and unlimited short-selling is allowed.

D)   Transactions costs are small for large investors.

The correct answer was D)

The derivation of the CAPM requires the assumption that transactions costs, and taxes are zero for all investors. The other three choices are necessary assumptions.

4．According to the capital asset pricing model (CAPM), if the expected return on an asset is too low given its beta, investors will:

A)   sell the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

B)   sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

C)   buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

D)   buy the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

The correct answer was B)

The CAPM is an equilibrium model: its predictions result from market forces acting to return the market to equilibrium. If the expected return on an asset is temporarily too low given its beta according to the SML (which means the market price is too high), investors will sell the stock until the price falls to the point where the expected return is again equal to that predicted by the SML

5．Howard Michaels, CFA, is an analyst for Donaldson Associates. Michaels is considering recommending a position in the retail sector for Donaldson’s institutional clients. Michaels has gathered the following information to help his guide his decision. Based on previous research, Michaels expects the market and Treasury bills to return 10 percent and 4 percent, respectively.

What would be the expected return for each investment, assuming the capital asset pricing model (CAPM) holds?

A)   Discount = 13%;             Everything = 10%.

B)   Discount = 19%;             Everything = 14%.

C)   Discount = 13%;             Everything = 14%.

D)   Discount = 19%;             Everything = 10%.

The correct answer was A)

The expected return is the return predicted by the CAPM for a given level of systematic risk (β). To calculate the expected return for each investment, use the following formula:

E(R_i) = R_F + β_i (E(R_M – R_F))

Therefore, the required for $1 Discount = 4% + 1.5´(10% – 4%) = 13%. Similarly, the expected return for Everything $5 = 4% + 1.0 ´ (10% – 4%) = 10%.