Reading 51: An Introduction to Asset Pricing Models LOS a习 capital, including, following, 2010

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LOS a, (Part 1): Explain the capital market theory, including its underlying assumptions.

Which of the following is NOT an assumption of capital market theory?

A) The capital markets are in equilibrium.

B) Interest rates never change from period to period.

C) Investors can lend at the risk-free rate, but borrow at a higher rate.

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Capital market theory assumes that investors can borrow or lend at the risk-free rate. The other statements are basic assumptions of capital market theory.

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Which of the following is an assumption of capital market theory? All investors:

A) select portfolios that lie above the efficient frontier to optimize the risk-return relationship.

B) have multiple-period time horizons.

C) see the same risk/return distribution for a given stock.

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All investors select portfolios that lie along the efficient frontier, based on their utility functions. All investors have the same one-period time horizon, and have the same risk/return expectations.

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Which is NOT an assumption of capital market theory?

A) There are no taxes or transaction costs.

B) Investments are not divisible.

C) There is no inflation.

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Capital market theory assumes that all investments are infinitely divisible. The other statements are basic assumptions of capital market theory.

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LOS a, (Part 2): Explain the effect on expected returns, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets.

The slope of the capital market line (CML) is a measure of the level of:

A) excess return per unit of risk.

B) expected return over the level of inflation.

C) risk over the level of excess return.

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The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of risk.

 

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Which of the following is the vertical axis intercept for the Capital Market Line (CML)?

A) Expected return on the market.

B) Expected return on the portfolio.

C) Risk-free rate.

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The CML originates on the vertical axis from the point of the risk-free rate.

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According to capital market theory, which of the following represents the risky portfolio that should be held by all investors who desire to hold risky assets?

A) The point of tangency between the capital market line (CML) and the efficient frontier.

B) Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier.

C) Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier.

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Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is suboptimal, and points above the CML are not feasible.

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All portfolios on the capital market line are:

A) unrelated except that they all contain the risk-free asset.

B) distinct from each other.

C) perfectly positively correlated.

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The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math implies that any two assets falling on this line will be perfectly, positively correlated with each other. Note: When r_a,b = 1, then the equation for risk changes to sport = W_As_A + W_Bs_B, which is a straight line.