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Reading 51: An Introduction to Asset Pricing Models - LOS

Q1. A basic assumption of the capital asset pricing model (CAPM) is that there are no transaction costs. If this assumption is relaxed, which of the following would be the least likely to occur?

A)   All securities will plot very close to the security market line.

B)   Diversification benefits will be realized up to the point that they offset transactions costs.

C)   Each investor can have a unique view of a security market line.

Q2. 21st Century Investments manages a portfolio, Z, that has zero correlation with the market index and examines the prospects for AMI Enterprises, a manufacturer of laptop batteries. 21st Century Investments derives the following market forecasts:

  • Expected return on portfolio Z -   8%

  • Expected return on the market index -  14%

  • Risk-free rate -  5%

  • AMI beta -  1.50

Using the zero-beta form of the capital asset pricing model (CAPM), the equilibrium expected return for AMI is closest to:

A)   17.0%.

B)   18.5%.

C)   14.0%.

Q3. Andrew Howell uses the security market line (SML) to make investment decisions. His firm incurs 2% transaction costs on all purchases. How does the existence of the 2% transaction cost change the intercept and slope of the SML for stock purchases faced by Howell’s firm?

          Intercept                                     Slope

 

A)  Increase by 2%                      No change

B)  No change                             Increase by 2%

C)  No change                             No change

Q4. The security market line (SML) will resemble a band with fairly tight upper and lower bounds if two of the following assumptions are made. Which of the following should not be included in this list?

A)   Unequal borrowing and lending rates.

B)   Differences in investor tax brackets.

C)   Heterogeneous investor expectations.

Q5. Which of the following assumptions associated with the capital asset pricing model (CAPM), when relaxed, will be least likely to result in turning the security market line (SML) into a band rather than a line?

A)   Equal borrowing and lending rates.

B)   A single holding period.

C)   No transaction costs.

答案和详解如下:

Q1. A basic assumption of the capital asset pricing model (CAPM) is that there are no transaction costs. If this assumption is relaxed, which of the following would be the least likely to occur?

A)   All securities will plot very close to the security market line.

B)   Diversification benefits will be realized up to the point that they offset transactions costs.

C)   Each investor can have a unique view of a security market line.

Correct answer is C)

If the assumption of “no transaction cost” is relaxed, then investors will correct mispricing only up to the point where transaction costs begin to offset potential excess return. As a result, all securities will plot within a band around the SML. It also would impact diversification, since at some point the transaction cost will offset the benefits of diversification.

Q2. 21st Century Investments manages a portfolio, Z, that has zero correlation with the market index and examines the prospects for AMI Enterprises, a manufacturer of laptop batteries. 21st Century Investments derives the following market forecasts:

  • Expected return on portfolio Z -   8%

  • Expected return on the market index -  14%

  • Risk-free rate -  5%

  • AMI beta -  1.50

Using the zero-beta form of the capital asset pricing model (CAPM), the equilibrium expected return for AMI is closest to:

A)   17.0%.

B)   18.5%.

C)   14.0%.

Correct answer is A)

The zero beta form of the CAPM replaces the risk-free rate with the return on a zero beta portfolio. Portfolio Z has zero correlation with the market portfolio. Therefore, the beta for portfolio Z also equals zero. Recall the formula for beta:

where covim is the covariance between any asset i and the market index m, σi is the standard deviation of returns for asset i, σm is the standard deviation of returns for the market index, and ρim is the correlation between asset i and the market index. Therefore, the beta will equal zero if the correlation equals zero.

The equation for the zero-beta CAPM is:

E(R) = E(Rz) + β[E(Rm) – E(Rz)] = 0.08 + 1.50[0.14 – 0.08] = 0.17 = 17%

Q3. Andrew Howell uses the security market line (SML) to make investment decisions. His firm incurs 2% transaction costs on all purchases. How does the existence of the 2% transaction cost change the intercept and slope of the SML for stock purchases faced by Howell’s firm?

          Intercept                                     Slope

 

A)  Increase by 2%                      No change

B)  No change                             Increase by 2%

C)  No change                             No change

Correct answer is A)

The existence of transaction costs causes the SML to change from a line to a thick band. The width of the band equals the transactions cost (2% above the line for purchases, and 2% below the line for sales). The question asks about purchases, so the intercept will increase by 2%. There is no change in the slope if the 2% transaction applies to all stocks as stated in the question.

Q4. The security market line (SML) will resemble a band with fairly tight upper and lower bounds if two of the following assumptions are made. Which of the following should not be included in this list?

A)   Unequal borrowing and lending rates.

B)   Differences in investor tax brackets.

C)   Heterogeneous investor expectations.

Correct answer is A)

If investors have heterogeneous expectations, transaction costs are not assumed to be zero, or differences in tax brackets are present, the SML becomes a band rather than a line. Differences in borrowing and lending rates can be assumed to be appropriate and used in the construction of the capital market line (CML). The result is a CML that is bent around the market portfolio. The portion of the CML connecting the risk-free asset and market portfolio will have a steeper slope than the portion of the CML extending beyond the market portfolio.

Q5. Which of the following assumptions associated with the capital asset pricing model (CAPM), when relaxed, will be least likely to result in turning the security market line (SML) into a band rather than a line?

A)   Equal borrowing and lending rates.

B)   A single holding period.

C)   No transaction costs.

Correct answer is A)

If the assumption of equal borrowing and lending rates is relaxed then the CAPM cannot be derived since there is no unique market portfolio. In effect, the CML will become kinked.

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