bapswarrior

How are the capital market line (CML) and the security market line (SML) similar?

A) The CML and SML use the standard deviation as a risk measure.

B) The CML and SML can be used to find the expected return of a portfolio.

C) The market portfolio will plot directly on the CML and the SML.

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All portfolios will plot on the SML. The only portfolio that will plot on the CML is the market portfolio, because it is perfectly diversified.

bapswarrior

The security market line (SML) is a graphical representation of the relationship between return and:

A) systematic risk.

B) unsystematic risk.

C) total risk.

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The SML graphically represents the relationship between return and systematic risk as measured by beta.

bapswarrior

Rachel Stephens, CFA, examines data for two computer stocks, AAA and BBB, and derives the following results:

• Standard deviation for AAA is 0.50.
• Standard deviation for BBB is 0.50.
• Standard deviation for the S&P500 is 0.20.
• Correlation between AAA and the S&P500 is 0.60.
• Beta for BBB is 1.00.

Stephens is asked to identify the stock that has the highest systematic risk and the stock that has the highest unsystematic risk. Stephens should draw the following conclusions:

Highest Systematic Risk

Highest Unsystematic Risk

A) Stock AAA Stock AAA

B) Stock BBB Stock AAA

C) Stock AAA Stock BBB

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First, compare the betas for the two stocks. The beta for AAA can be derived with the formula:
Therefore, AAA has larger beta and greater systematic risk than stock BBB which has a beta equal to 1. To assess the unsystematic risk, note that total risk is measured by the standard deviation. Note that the standard deviations for AAA and BBB are identical. Therefore, AAA and BBB have identical total risk. Moreover, note that:total risk = systematic risk + unsystematic risk.
We have already concluded that both stocks have identical total risk and that AAA has greater systematic risk. Therefore, BBB must have higher unsystematic risk.

bapswarrior

Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of 0.6. Which of the following statements is most accurate?

A) The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc.

B) The stock of Kaskin, Inc., has more total risk than Quinn, Inc.

C) The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.

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Beta is a measure of systematic risk. Since only systematic risk is rewarded, it is safe to conclude that the expected return will be higher for Kaskin’s stock than for Quinn’s stock.

bapswarrior

Glimmer Glass has a correlation of 0.67 with the market portfolio, a variance of 23%, and an expected return of 14%. The market portfolio has an expected return of 11% and a variance of 13%. Glimmer stock is approximately:

A) 11% less volatile than the average stock.

B) 4% more volatile than the average stock.

C) 19% more volatile than the average stock.

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Beta is equal to the covariance divided by the market portfolio variance, or the product of the correlation and the ratio of the stock standard deviation to the market standard deviation. To derive the standard deviation, we take the square root of the variance. So beta = 0.67 × 0.479583 / 0.360555 = 0.891183. Glimmer shares are about 11% less volatile than the average stock.

bapswarrior

Which of the following statements about using the capital asset pricing model (CAPM) to value stocks is least accurate?

A) The CAPM reflects unsystematic risk using standard deviation.

B) If the CAPM expected return is too low, then the asset’s price is too high.

C) The model reflects how market forces restore investment prices to equilibrium levels.

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The capital asset pricing model assumes all investors hold the market portfolio, and as such unsystematic risk, or risk not related to the market, does not matter. Thus, the CAPM does not reflect unsystematic risk and does not rely on standard deviation as the measure of risk but instead uses beta as the measure of risk. The remaining statements are accurate.

bapswarrior

The capital market line:

A) helps determine asset allocation.

B) uses nondiversifiable risk.

C) has a slope equal to the market risk premium.

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The purpose of the CML is to determine the percentages allocated to the market portfolio and the risk-free asset. Both remaining answers reflect characteristics of the security market line.

bapswarrior

Jim Williams, CFA, manages individual investors' portfolios for Clarence Farlow Associates. Clarence Farlow Jr., CEO of Clarence Farlow Associates, is looking for some new investment ideas. Farlow is obsessive about value, however, and never buys stocks that look expensive. He has assigned Williams to assess the investment merits of several securities. Specifically, Williams has collected the following data for three possible investments.

Stock	Price Today	Forecasted Price*	Dividend	Beta
Alpha	25	31	2	1.6
Omega	105	110	1	1.2
Lambda	10	10.80	0	0.5
*Forecast Price = expected price one year from today.

Williams plans to value the three securities using the security market line, and has assembled the following information for use in his valuation:

• Securities markets are in equilibrium.
• The prime interest rate is expected to rise by about 2% in the year ahead.
• Inflation is expected to be 1% over the upcoming year.
• The expected return on the market is 12% and the risk-free rate is 4%.
• The market portfolio's standard deviation is 40%.

Williams eventually decides to construct a portfolio consisting of 10 shares of Alpha, 2 shares of Omega, and 20 shares of Lambda.Based on valuation via the SML, which of the following statements is most accurate?

A) Williams should buy Alpha but not Omega.

B) Both Alpha and Omega are overpriced.

C) Neither Alpha nor Lambda is correctly priced.

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SML valuation hinges on the relationship between the forecasted return (FR) and expected return (ER).

FR = (ending price − beginning price + dividends) / beginning price.

ER = RFR + β (RMkt − RFR).

• For Alpha: FR = (31 − 25 + 2) / 25 = 32%, ER = 4 + 1.6(12 − 4) = 16.8%.
  Since FR > ER, stock is underpriced.
  

• For Omega: FR = (110 − 105 + 1) / 105 = 5.7%, ER = 4 + 1.2(12 − 4) = 13.6%.
  Since FR < ER, stock is overpriced.
  

• For Lambda: FR = (10.8 − 10 + 0) / 10 = 8%, ER = 4 + 0.5(12 − 4) = 8%.
  Since FR = ER, stock is correctly priced.

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The covariance of Omega with the market portfolio is closest to:

A) 0.576.

B) 0.480.

C) 0.192.

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Beta = covi,M / market portfolio variance, so covi,M = 1.2 × (0.4)2 = 0.192.

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Williams calculates the required return for Omega. According to the capital asset pricing model (CAPM) the required return is closest to:

A) 12.0%.

B) 13.6%.

C) 5.7%.

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The required return (RR) uses the equation of the SML: risk-free rate + Beta × (expected market rate − risk-free rate). For Omega, RR = 4 + 1.2(12 − 4) = 13.6%. The expected return of 5.7% need not be the same as the required return under CAPM.

bapswarrior

The single-factor market model predicts that the covariance between two assets (asset i and asset j) is equal to:

A) the beta of i times the beta of j.

B) the beta of i times the beta of j divided by the standard deviation of the market portfolio.

C) the beta of i times the beta of j times the variance of the market portfolio.

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One of the predictions of the single-factor market model is that Cov(Ri,Rj) = bibjsM2. In other words, the covariance between two assets is related to the betas of the two assets and the variance of the market portfolio.

bapswarrior

Joseph Capital Management is considering implementing a mean-variance optimization model as part of their portfolio management process, however, the firm’s investment committee is unsure whether the model should use historical estimates or market model estimates for the inputs to the model. Joseph’s Senior Portfolio Manager, Travis Palmer, puts together a memo to the committee contrasting the two methods of calculating inputs. The memo includes the following points:

Point 1:	Using the historical estimate is far simpler and involves fewer computations than the market model method.
Point 2:	The use of market model estimates implicitly assumes that the market itself is mean-variance efficient.
Point 3:	Both the use of market model estimates and historical estimates rely on historical data to some degree.
Point 4:	One of the problems with using market model estimates for estimating returns is that the market model implicitly assumes the market index is representative of the entire market.

After reviewing Palmer’s memo, Joseph’s investment committee would be CORRECT to:

A) agree with Point 3, but disagree with Points 2 and 4.

B) agree with Points 2 and 3, but disagree with Point 1.

C) agree with Points 1 and 4, but disagree with Point 3.

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The committee should disagree with Point 1. The use of historical estimates involves computing the covariance of between each stock in a portfolio with every other stock in the portfolio, while the use of the market model only relies on computing the covariance of each stock with the market index, resulting in fewer computations.
The committee should agree with Points 2, 3, and 4. The market model regresses historical returns of a stock/portfolio with the corresponding returns of a market index and implicitly assumes that historical relationships are reflective of future relationships. The market model also implicitly assumes that the market itself is mean-variance efficient and that the index used for market returns is representative of the entire market.