LOS a: Discuss the efficiency of the market portfolio in the CAPM and the relationship between the expected return and beta of an asset when there are restrictions on borrowing at the risk-free rate and on short selling.

Q1. If the market portfolio is not efficient then the relationship between each asset’s expected return and its respective beta:

A)   is affected such that the Treynor measure will yield unreliable rankings among assets.

B)   cannot be affected, because the assumption is false: the market portfolio is efficient by definition.

C)   is affected, but the Treynor measure will still yield reliable rankings among assets.

Q2. With respect to the CAPM, if there are restrictions on borrowing at the risk-free rate and on short selling, which of the following is least likely to be result of this condition?

A)   The relationship between each asset’s return and the market return is nonlinear.

B)   The process of adjusting portfolio risk by adjusting the portfolio beta to be more exact.

C)   The Treynor measure yields unreliable rankings among assets.

Q3. The capital asset pricing model (CAPM) assumes that investors can borrow at the risk-free rate and short sell, and also, that the market portfolio is efficient. With respect to the risk-free rate and selling short, the market portfolio may NOT be efficient:

A)   if either borrowing at the risk-free rate or short-selling is not possible.

B)   under no circumstances, the market portfolio is efficient by definition.

C)   if both borrowing at the risk-free rate and short-selling are not possible.

LOS a: Discuss the efficiency of the market portfolio in the CAPM and the relationship between the expected return and beta of an asset when there are restrictions on borrowing at the risk-free rate and on short selling. fficeffice" />

Q1. If the market portfolio is not efficient then the relationship between each asset’s expected return and its respective beta:

A)   is affected such that the Treynor measure will yield unreliable rankings among assets.

B)   cannot be affected, because the assumption is false: the market portfolio is efficient by definition.

C)   is affected, but the Treynor measure will still yield reliable rankings among assets.

Correct answer is A)

If investors are not able to short sell or borrow at the risk-free rate, the market portfolio may not be efficient. If the market portfolio is inefficient, the relationship between beta and expected return in the CAPM may not be linear. If this is the case, using the Treynor or Jensen measure to compare risk-adjusted performance can lead to unreliable rankings.

Q2. With respect to the CAPM, if there are restrictions on borrowing at the risk-free rate and on short selling, which of the following is least likely to be result of this condition?

A)   The relationship between each asset’s return and the market return is nonlinear.

B)   The process of adjusting portfolio risk by adjusting the portfolio beta to be more exact.

C)   The Treynor measure yields unreliable rankings among assets.

Correct answer is B)

If investors are not able to short sell or borrow at the risk-free rate, the market portfolio may not be efficient. If the market portfolio is inefficient, the relationship between beta and expected return in the CAPM may not be linear. If this is the case, using the Treynor or Jensen measure to compare risk-adjusted performance can lead to unreliable rankings. In addition, adjusting portfolio risk by adjusting the portfolio beta may not expose the investor to the desired level of risk, and this will make the adjustment of portfolio risk using a beta that is less exact.

Q3. The capital asset pricing model (CAPM) assumes that investors can borrow at the risk-free rate and short sell, and also, that the market portfolio is efficient. With respect to the risk-free rate and selling short, the market portfolio may NOT be efficient:

A)   if either borrowing at the risk-free rate or short-selling is not possible.

B)   under no circumstances, the market portfolio is efficient by definition.

C)   if both borrowing at the risk-free rate and short-selling are not possible.

Correct answer is A)

The capital market line (CML) relies on the assumption that the market portfolio is efficient. That is, the market portfolio lies on the efficient frontier and offers the highest possible level of return for its level of risk. If investors are not allowed or able to short sell or borrow at the risk-free rate, however, the market portfolio may not be efficient.

thx