andytrader

For an investor to move further up the Capital Market Line than the market portfolio, the investor must:

A) diversify the portfolio even more.

B) reduce the portfolio's risk below that of the market.

C) borrow and invest in the market portfolio.

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Portfolios that lie to the right of the market portfolio on the capital market line ("up" the capital market line) are created by borrowing funds to own more than 100% of the market portfolio (M).
The statement, "diversify the portfolio even more" is incorrect because the market portfolio is fully diversified.

andytrader

In the context of the CML, the market portfolio includes:

A) 12-18 stocks needed to provide maximum diversification.

B) all existing risky assets.

C) the risk-free asset.

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The market portfolio has to contain all the stocks, bonds, and risky assets in existence. Because this portfolio has all risky assets in it, it represents the ultimate or completely diversified portfolio.

andytrader

What is the risk measure associated with the CML?

A) Standard deviation.

B) Beta.

C) Market risk.

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In the context of the CML, the measure of risk (x-axis) is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML).

andytrader

Based on Capital Market Theory, an investor should choose the:

A) portfolio with the highest return on the Capital Market Line.

B) portfolio that maximizes his utility on the Capital Market Line.

C) market portfolio on the Capital Market Line.

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Given the Capital Market Line, the investor chooses the portfolio that maximizes his utility. That portfolio may be exactly the market portfolio or it may be some combination of the risk-free asset and the market portfolio.

andytrader

Which of the following statements about the capital market line (CML) is least accurate?

A) Investors choose a portfolio on the CML by varying their weightings of the risk-free asset and the market portfolio.

B) The CML will not be a linear relationship if investors' borrowing and lending rates are not equal.

C) The market portfolio lies on the CML and has only unsystematic risk.

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The first part of this statement is true - the market portfolio does lie on the CML. However, the market portfolio is well diversified and thus has no unsystematic risk. The risk that remains is market risk, or nondiversifiable, or systematic risk.
The CML measures standard deviation (or total risk) against returns. The CML will “kink” if the borrowing rate and lending rate are not equal. Investors choose a portfolio on the CML by lending or borrowing at the risk-free rate to vary the weighting of their investments in the risk-free asset and the market portfolio.

clearlycanadian

Which of the following is the risk that disappears in the portfolio construction process?

A) Unsystematic risk.

B) Systematic risk.

C) Interest rate risk.

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Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio.

clearlycanadian

Which of the following statements about systematic and unsystematic risk is least accurate?

A) Total risk equals market risk plus firm-specific risk.

B) The unsystematic risk for a specific firm is similar to the unsystematic risk for other firms in the same industry.

C) As an investor increases the number of stocks in a portfolio, the systematic risk will remain constant.

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This statement should read, "The unsystematic risk for a specific firm is not similar to the unsystematic risk for other firms in the same industry." Thus, other terms for this risk are firm-specific, or unique, risk.
Systematic risk is not diversifiable. As an investor increases the number of stocks in a portfolio the unsystematic risk will decrease at a decreasing rate. Total risk equals systematic (market) plus unsystematic (firm-specific) risk.

clearlycanadian

In the context of the capital market line (CML), which of the following statements is CORRECT?

A) The two classes of risk are market risk and systematic risk.

B) Market risk can be reduced through diversification.

C) Firm-specific risk can be reduced through diversification.

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The other statements are false. Market risk cannot be reduced through diversification; market risk = systematic risk. The two classes of risk are unsystematic risk and systematic risk.

clearlycanadian

Which of the following is least likely considered a source of systematic risk for bonds?

A) Purchasing power risk.

B) Market risk.

C) Default risk.

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Default risk is based on company-specific or unsystematic risk.

clearlycanadian

Which of the following statements about portfolio management is most accurate?

A) The security market line (SML) measures systematic and unsystematic risk versus expected return; the CML measures total risk.

B) As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches negative one.

C) Combining the capital market line (CML) (risk-free rate and efficient frontier) with an investor's indifference curve map separates out the decision to invest from the decision of what to invest in.

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Combining the CML (risk-free rate and efficient frontier) with an investor’s indifference curve map separates out the decision to invest from what to invest in and is called the separation theorem. The investment selection process is thus simplified from stock picking to efficient portfolio construction through diversification.
The other statements are false. As an investor diversifies away the unsystematic portion of risk, the correlation between his portfolio return and that of the market approaches positive one. (Remember that the market portfolio has no unsystematic risk). The SML measures systematic risk, or beta risk.