Reading 51: An Introduction to Asset Pricing Models - LOS

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Q1. Beta is least accurately described as:

A) a measure of the sensitivity of a security’s return to the market return.

B) a standardized measure of the total risk of a security.

C) the covariance of a security’s returns with the market return, divided by the variance of market returns.

Q2. Which of the following statements regarding the Capital Asset Pricing Model is least accurate?

A) It is when the security market line (SML) and capital market line (CML) converge.

B) It is useful for determining an appropriate discount rate.

C) Its accuracy depends upon the accuracy of the beta estimates.

Q3. Todd Karabon, a junior analyst for investment boutique Marsh & Sons, has just been assigned his first security-analysis project. Before he starts crunching numbers, Karabon decides to review his portfolio theory.

Karabon starts with a look at capital market theory. He remembers that the theory requires a number of assumptions, and he jots some of them down:

Every investor has the same time horizon.
Investors can borrow at the risk-free rate and know in advance about their real cash flows.
All investors make investment decisions for the same reasons, considering only expected return and standard deviation.
Every investor has the same market expectations, which allows for the identification of the optimal portfolio.

The market portfolio is key to modern portfolio theory, its existence creating a new strategy for maximizing portfolio return. As a refresher, Karabon records some thoughts about the market portfolio:

The risk of the market portfolio is measured in both standard deviation and systematic risk.
No portfolio along the Markowitz efficient frontier has a higher Sharpe ratio than the market portfolio.
The CML and the Markowitz efficient frontier intercept at the market portfolio.
The market portfolio is uninvestable.

Marsh & Sons has provided Karabon with data sheets on a number of companies. The first one the analyst considers is Ofin Finance, a consumer-lending company. The sheet contains the following data: expected returns for the stock, the market risk premium, beta, and the risk-free rate of return. Karabon attempts to graph the SML to determine whether the stock is cheaply priced.

The analyst follows up his analysis of Ofin with a review of a half-dozen other stocks. While the SML is a useful tool for assessing valuation, Karabon is not satisfied. He decides to tweak his valuation model by relaxing some of the assumptions used to calculate the SML.

First, Karabon assumes that investors cannot borrow or lend at the risk-free rate. Eliminating the assumption changes the look of the SML graph. Next, Karabon goes down the list of assumptions and determines that every time he relaxes one of the CAPM assumptions, the SML changes dramatically.

When Karabon relaxed one of the CAPM assumptions, the SML looked different depending on the size of the stock. He was relaxing the assumption of:

A) no transaction costs.

B) efficient markets.

C) no taxes.

Q4. Which of Karabon’s assumptions about the capital market theory is least accurate?

A) Investors can borrow at the risk-free rate and know in advance about their real cash flows.

B) All investors make investment decisions for the same reasons, considering only expected return and standard deviation.

C) Every investor has the same time horizon.

Q5. The risk-free asset is least likely to be/have:

A) needed to calculate the CML.

B) needed to calculate beta.

C) the point at which the SML intercepts the y-axis.