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An investor is considering an investment. After a great deal of careful research he determines that the forecasted return on the investment is 15% and estimates the beta to be 2.0. The risk-free rate of interest is 3%, and the return on the market is 13%. Should the project be undertaken?
A)
No, the forecasted return is less than the expected return of 23%.
B)
Yes, the forecasted return is less than the expected return of 18%.
C)
Yes, the forecasted return is more than the expected return of 13%.


Per the Capital Asset Pricing Model (CAPM), the expected rate of return
= Rf + b[E(Rm) – Rf]
= 3 + 2(13.0 − 3.0) = 23%.

Since the forecated return of 15% is less than expected rate of return of 23%, the investment should not be undertaken.

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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 market price of risk is the slope of the capital market line.



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.

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Which of the following is NOT an assumption necessary to derive the capital asset pricing model (CAPM)?
A)
Investors only need to know expected returns, variances, and covariances in order create optimal portfolios.
B)
Transactions costs are small for large investors.
C)
Investors are price takers whose buy and sell decisions don't affect asset prices.



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

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The best possible risk-return trade-off attainable, given the investor’s expectations of expected returns, variances, and covariances, is represented by the:
A)
the slope of the minimum-variance frontier at the global minimum-variance portfolio.
B)
slope of the capital allocation line (CAL).
C)
standard deviation of the market portfolio.



We can interpret the slope coefficient [(E(RT) − RF) / sT] of the CAL the same way we do the slope of any straight line (it’s the change in E(RT) for a one unit change in sT). Thus, it represents the risk-return trade from moving along the CAL and how much additional expected return do we get for a one-unit increase in risk. Because the tangency portfolio T is the best portfolio, the slope of the CAL line represents the best possible risk-return trade-off attainable, given the investor’s expectations of expected returns, variances, and covariances.

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Portfolio Management Associates (PMA) provides asset allocation advice for pensions. PMA recommends that all their pension clients select an appropriate weighting of the risk-free asset and the market portfolio. PMA should explain to its clients that the market portfolio is selected because the market portfolio:
A)
maximizes return and minimizes risk.
B)
maximizes the Sharpe ratio.
C)
maximizes return.



The risk and return coordinate for the market portfolio is the tangency point for the capital market line (CML). The CML has the steepest slope of any possible portfolio combination. The slope of the CML is the Sharpe ratio. Therefore, the Sharpe ratio is highest for the market portfolio

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Investment Management Inc. (IMI) uses the capital market line to make asset allocation recommendations. IMI derives the following forecasts:
  • Expected return on the market portfolio: 12%
  • Standard deviation on the market portfolio: 20%
  • Risk-free rate: 5%

Samuel Johnson seeks IMI’s advice for a portfolio asset allocation. Johnson informs IMI that he wants the standard deviation of the portfolio to equal one half of the standard deviation for the market portfolio. Using the capital market line, the expected return that IMI can provide subject to Johnson’s risk constraint is closest to:
A)
6.0%.
B)
8.5%.
C)
7.5%.


The equation for the capital market line is:
Johnson requests the portfolio standard deviation to equal one half of the market portfolio standard deviation. The market portfolio standard deviation equals 20%. Therefore, Johnson’s portfolio should have a standard deviation equal to 10%. The intercept of the capital market line equals the risk free rate (5%), and the slope of the capital market line equals the Sharpe ratio for the market portfolio (35%). Therefore, using the capital market line, the expected return on Johnson’s portfolio will equal:

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If an investors’ portfolio lies on the capital market line (CML) at the point where the CML touches the efficient frontier then this implies the investor has:
A)

less than 100% of their money invested in the market portfolio.
B)

100% of their funds invested in the market portfolio.
C)

a larger percentage of their money invested in the market portfolio and have loaned the remaining amount at the risk-free rate.



Portfolios that are on the CML where the CML touches the efficient frontier implies that 100% of investors funds should be invested in the market portfolio to achieve greatest utility.

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Adrian Jones is the portfolio manager for Asset Allocators, Inc., (AAI). Jones has decided to alter her framework of analysis. Previously, Jones made recommendations among efficient portfolios of risky assets only. Now, Jones has decided to make recommendations that include the risk-free asset. The efficient frontier for Jones has changed shape from a:
A)
curve to the thick curve.
B)
line to a curve.
C)
curve to a line.



Initially, Jones selected only efficient portfolios comprising risky assets. Formally, Jones selected portfolios along the Markowitz efficient frontier (a curve). When Jones decided to add the risk-free asset, her efficient frontier changed from a curve (the Markowitz efficient frontier) to a line (the capital market line). The capital market line starts at the risk-free rate and extends along (tangent to) the Markowitz curve.

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The capital allocation line (CAL) with the market portfolio as the tangency portfolio is the:
A)
minimum variance line.
B)
capital market line.
C)
security market line.



The capital market line is the capital allocation line with the market portfolio as the tangency portfolio.

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If a risk-free asset is part of the investment opportunity set, then the efficient frontier is a:
A)
curve called the minimum-variance frontier.
B)
curve called the efficient portfolio set.
C)
straight line called the capital allocation line (CAL).



If a risk-free investment is part of the investment opportunity set, then the efficient frontier is a straight line called the capital allocation line (CAL), whether or not risky asset correlations are equal to one. The y-intercept of the CAL is the risk-free rate. The CAL is tangent to the minimum-variance frontier of risky assets.

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