Iamp 7
Iamp 7
Iamp 7
CHAPTER 7
QUESTIONS
1. Draw a graph that shows what happens to the Markowitz efficient frontier when
you combine a risk-free asset with alternative risky asset portfolios on the
Markowitz efficient frontier. Explain why the line from the RFR that is tangent to
the efficient frontier defines the dominant set of portfolio possibilities.
It can be shown that the expected return function is a weighted average of the individual
returns. In addition, it is shown that combining any portfolio with the risk-free asset, that
the standard deviation of the combination is only a function of the weight for the risky
asset portfolio. Therefore, since both the expected return and the variance are simple
weighted averages, the combination will lie along a straight line.
2.
Expected Rate
of Return *F
M*
P*
*B
RFR *A
The existence of a risk-free asset excludes the E-A segment of the efficient frontier
because any point below A is dominated by the RFR. In fact, the entire efficient frontier
below M is dominated by points on the RFR-M Line (combinations obtained by investing
a part of the portfolio in the risk-free asset and the remainder in M), e.g., the point P
dominates the previously efficient B because it has lower risk for the same level of return.
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As shown, M is at the point where the ray from RFR is tangent to the efficient frontier.
The new efficient frontier thus becomes RFR-M-F.
3. Expected Rate
of Return
M
C
B
RFR A
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This figure indicates what happens as a risk-free asset is combined with risky portfolios
higher and higher on the efficient frontier. In each case, as you combine with the higher
return portfolio, the new line will dominate all portfolios below this line. This program
continues until you combine with the portfolio at the point of tangency and this line
becomes dominant over all prior lines. It is not possible to do any better because there are
no further risky asset portfolios at a higher point.
4. The “M” or “market” portfolio contains all risky assets available. If a risky asset, be it an
obscure bond or a rare stamp, was not included in the market portfolio, then there would
be no demand for this asset, and consequently, its price would fall. Notably, the price
decline would continue to the point where the return would make the asset desirable such
that it would be part of the M portfolio - e.g., if the bonds of ABC Corporation were
selling for 100 and had a coupon of 8 percent, the investor’s return would be 8 percent;
however, if there was no demand for ABC bonds the price would fall, say to 80, at which
point the 10 percent (80/800) return might make it a desirable investment. Conversely, if
the demand for ABC bonds was greater than supply, prices would be bid up to the point
where the return would be in equilibrium. In either case, ABC bonds would be included
in the market portfolio.
5. Leverage indicates the ability to borrow funds and invest these added funds in the market
portfolio of risky assets. The idea is to increase the risk of the portfolio (because of the
leverage), and also the expected return from the portfolio. It is shown that if you can
borrow at the RFR then the set of leveraged portfolios is simply a linear extension of the
set of portfolios along the line from the RFR to the market portfolio. Therefore, the full
CML becomes a line from the RFR to the M portfolio and continuing upward.
6. You can measure how well diversified a portfolio is by computing the extent of
correlation between the portfolio in question and a completely diversified portfolio - i.e.,
the market portfolio. The idea is that, if a portfolio is completely diversified and,
therefore, has only systematic risk, it should be perfectly correlated with another portfolio
that only has systematic risk.
7. What changes would you expect in the standard deviation for a portfolio
of between 4 and 10 stocks, between 10 and 20 stocks, and between 50
and 100 stocks?
8. Given the existence of the CML, everyone should invest in the same risky asset portfolio,
the market portfolio. The only difference among individual investors should be in the
financing decision they make, which depends upon their risk preference. Specifically,
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9. Recall that the relevant risk variable for an individual security in a portfolio is its average
covariance with all other risky assets in the portfolio. Given the CML, however, there is
only one relevant portfolio and this portfolio is the market portfolio that contains all risky
assets. Therefore, the relevant risk measure for an individual risky asset is its covariance
with all other assets, namely the market portfolio.
10. Systematic risk refers to that portion of total variability of returns caused by factors
affecting the prices of all securities, e.g., economic, political and sociological changes -
factors that are uncontrollable, external, and broad in their effect on all securities.
Unsystematic risk refers to factors that are internal and “unique” to the industry or
company, e.g., management capability, consumer preferences, labor strikes, etc. Notably,
it is not possible to get rid of the overall systematic risk, but it is possible to eliminate the
“unique” risk for an individual asset in a diversified portfolio.
11. The capital asset pricing model (CAPM) contends that there is
systematic and unsystematic risk for an individual security. Which is
the relevant risk variable and why is it relevant? Why is the other risk
variable not relevant
In a capital asset pricing model (CAPM) world the relevant risk variable is the security’s
systematic risk - its covariance of return with all other risky assets in the market. This
risk cannot be eliminated. The unsystematic risk is not relevant because it can be
eliminated through diversification - for instance, when you hold a large number of
securities, the poor management capability, etc., of some companies will be offset by the
above average capability of others.
12. What are the similarities and differences between the CML and SML as
models of the riskreturn trade-off?
For plotting, the SML the vertical axis measures the rate of return while the horizontal
axis measures normalized systematic risk (the security’s covariance of return with the
market portfolio divided by the variance of the market portfolio). By definition, the beta
(normalized systematic risk) for the market portfolio is 1.0 and is zero for the risk-free
asset. It differs from the CML where the measure of risk is the standard deviation of
return (referred to as total risk).
13. While the capital asset pricing model (CAPM) has been widely used to analyze securities and
manage portfolios for the past 50 years, it has also been widely criticized as providing too
simple a view of risk. Describe three problems in relation to the definition and estimation of
the beta measure in the CAPM that would support this criticism.
CFA Examination I (1993)
Any three of the following are criticisms of beta as used in CAPM.
1. Theory does not measure up to practice. In theory, a security with a zero beta should
give a return exactly equal to the risk-free rate. But actual results do not come out that
way, implying that the market values something besides a beta measure of risk.
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2. Beta is a fickle short-term performer. Some short-term studies have shown risk and
return to be negatively related. For example, Black, Jensen and Scholes found that from
April 1957 through December 1965, securities with higher risk produced lower returns
than less risky securities. This result suggests that (1) in some short periods, investors
may be penalized for taking on more risk, (2) in the long run, investors are not rewarded
enough for high risk and are overcompensated for buying securities with low risk, and (3)
in all periods, some unsystematic risk is being valued by the market.
3. Estimated betas are unstable. Major changes in a company affecting the character of
the stock or some unforeseen event not reflected in past returns may decisively affect the
security’s future returns.
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4. Beta is easily rolled over. Richard Roll has demonstrated that by changing the market
index against which betas are measured, one can obtain quite different measures of the
risk level of individual stocks and portfolios. As a result, one would make different
predictions about the expected returns, and by changing indexes, one could change the
risk-adjusted performance ranking of a manager.
14. You have been offered an opportunity to invest in one of the two fully diversified portfolios,
Portfolio H and Portfolio L. While you know that the betas of these portfolios are identical,
you only know that, on average, the stocks held in Portfolio H have a higher level of specific
risk than those in Portfolio L. From what you know about the capital asset pricing model
(CAPM), which portfolio should you invest in? Which portfolio should give you a higher
expected return?
Since both portfolios are fully diversified, it doesn’t matter if the specified risk for each
individual security is high or low. The specific risk has been diversified away for both
portfolios.
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specific risk. By including a sufficiently large number of holdings, the specific risk of the
individual holdings offset each other, diversifying away much of the overall specific risk
and leaving mostly nondiversifiable or market-related risk.
Systematic risk is market-related risk that cannot be diversified away. Because systematic
risk cannot be diversified away, investors are rewarded for assuming this risk.
Covariance measures the extent to which two securities tend to move, or not move,
together. The level of covariance is heavily influenced by the degree of correlation
between the securities (the correlation coefficient) as well as by each security’s standard
deviation. As long as the correlation coefficient is less than 1, the portfolio standard
deviation is less than the weighted average of the individual securities’ standard
deviations. The lower the correlation, the lower the covariance and the greater the
diversification benefits (negative correlations provide more diversification benefits than
positive correlations).
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The capital asset pricing model (CAPM) asserts that investors will hold only fully
diversified portfolios. Hence, total risk as measured by the standard deviation is not
relevant because it includes specific risk (which can be diversified away).
Under the CAPM, beta measures the systematic risk of an individual security or portfolio.
Beta is the slope of the characteristic line that relates a security’s returns to the returns of
the market portfolio. By definition, the market itself has a beta of 1.0. The beta of a
portfolio is the weighted average of the betas of each security contained in the portfolio.
Portfolios with betas greater than 1.0 have systematic risk higher than that of the market;
portfolios with betas less than 1.0 have lower systematic risk. By adding securities with
betas that are higher (lower), the systematic risk (beta) of the portfolio can be increased
(decreased) as desired.
15 Explain the effect on both portfolio risk and return that would result from
the addi\tion of U.S. real estate. Include in your answer two reasons for
any change you expect in portfolio risk. (Note: It is not necessary to
compute expected risk and return.)
(b). Without performing the calculations, one can see that the portfolio return would increase
because: (1) Real estate has an expected return equal to that of stocks. (2) Its expected
return is higher than the return on bonds.
The addition of real estate would result in a reduction of risk because: (1) The standard
deviation of real estate is less than that of both stocks and bonds. (2) The covariance of
real estate with both stocks and bonds is negative.
The addition of an asset class that is not perfectly correlated with existing assets will
reduce variance. The fact that real estate has a negative covariance with the existing asset
classes will reduce risk even more.
(c). Capital market theory holds that efficient markets prevent mispricing of assets and that
expected return is proportionate to the level of risk taken. In this instance, real estate is
expected to provide the same return as stocks and a higher return than bonds. Yet, it is
expected to provide this return at a lower level of risk than both bonds and stocks. If these
expectations were realistic, investors would sell the other asset classes and buy real
estate, pushing down its return until it was proportionate to the level of risk.
Appraised values differ from transaction prices, reducing the accuracy of return and
volatility measures for real estate. Capital market theory was developed and applied to
the stock market, which is a very liquid market with relatively small transaction costs. In
contrast to the stock market, real estate markets are very thin and lack liquidity.
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16. First, the stability of beta: It is important to know whether it is possible to use past betas
as estimates of future betas. Second, is there a relationship between beta and rates of
return? This would indicate whether the CAPM is a relevant pricing model that can
explain rates of return on risky assets.
17. Given that beta is the principal risk measure, stable betas make it easier to forecast future
beta measures of systematic risk - i.e., can betas measured from past data be used in
making investment decisions?
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18. The results of the stability of beta studies indicate that betas for individual stocks are
generally not stable, but portfolios of stocks have stable betas.
19. Is there a positive linear relationship between the systematic risk of risky assets and the
rates of return on these assets? Are the coefficients positive and significant? Is the
intercept close to the risk-free rate of return?
20.Draw an ideal SML. Based on the early empirical results, what did the actual
risk-return relationship look like relative to the ideal relationship implied by the
CAPM?
RFR
RM
21. According to the CAPM, what assets are included in the market portfolio, and what
are the relative weightings? In empirical studies of the CAPM, what are the typical
proxies used for the market portfolio? Assuming that the empirical proxy for the
market portfolio is not a good proxy, what factors related to the CAPM will be
affected
The “market” portfolio contains all risky assets available. If a risky asset, be it an obscure
bond or rare stamp, was not included in the market portfolio, then there would be no
demand for this asset and, consequently, its price would fall. Notably, the price decline
would continue to the point where the return would make the asset desirable such that it
would be part of the “market” portfolio. The weights for all risky assets are equal to their
relative market value.
22. According to Roll, a mistakenly specified proxy for the market portfolio can have two
effects. First, the beta computed for alternative portfolios would be wrong because the
market portfolio is inappropriate. Second, the SML derived would be wrong because it
goes from the RFR through the improperly specified market portfolio. In general, when
comparing the performance of a portfolio manager to the “benchmark” portfolio, these
errors will tend to overestimate the performance of portfolio managers because the proxy
market portfolio employed is probably not as efficient as the true market portfolio, so the
slope of the SML will be underestimated.
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23. Some studies related to the efficient market hypothesis generated results that
implied additional factors beyond beta should be considered to estimate expected
returns. What are these other variables and why should they be considered?
Studies of the efficient markets hypothesis suggest that additional factors affecting
estimates of expected returns include firm size, the price-earnings ratio, and financial
leverage. These variables have been shown to have predictive ability with respect to
security returns.
24. Fama and French found that size, leverage, earnings-price ratios, and book value to
market value of equity all have a significant impact on univariate tests on average return.
In multivariate tests, size and book to market equity value are the major explanatory
factors.
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PROBLEMS
Assume that you expect the economy’s rate of inflation to be 3 percent, giving an RFR
of 6 percent and a market return (RM) of 12 percent.
a. Draw the SML under these assumptions.
b. Subsequently, you expect the rate of inflation to increase from 3 percent to 6 percent.
What effect would this have on the RFR and the RM? Draw another SML on the graph
from Part a.
1. Rate of SMLc
Return
SMLb
E(Rmc) .17
SMLc
E(Rmb) .15
E(Rmc) .12
RFRc=RFRb .09
RFRa .06
In (b), a change in risk-free rate, with other things being equal, would result in a new
SMLb, which would intercept with the vertical axis at the new risk-free rate (.09) and
would be parallel in the original SMLa.
In (c), this indicates that not only did the risk-free rate change from .06 to .09, but the
market risk premium per unit of risk [E(Rm) - Rf] also changed from .06 (.12 - .06) to
.08 (.17 - .09). Therefore, the new SML c will have an intercept at .09 and a different
slope so it will no longer be parallel to SMLa.
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N 48 51 2.00 51 48 2.00
48 .1042
D 37 40 1.25 40 37 1.25
37 .1149
If you believe the appropriateness of these estimated returns, you would buy stocks D
and sell stocks U and N.
E(R)
N
14% U
*U’
* N’
*D’
D
4. Student Exercise
5. Student Exercise
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6. Student Exercise
7. Student Exercise
8. Student Exercise
9. Student Exercise
11(a).
COVi,m = (ri,m)(i )( m)
For Intel:
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.00479 .00479
Beta = (.055)2 = = 1.597
.0030
For Ford:
.00265
Beta = = .883
.0030
For Merck:
.00337
Beta = = 1.123
.0030
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RM = .15 *Ford
.10 *Merck
RFR=.08
1.0 Beta
13.
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1 68.33
201.89 oM 8.27
14.21
COV1, 92.00
M
15.33
6
13(b). The standard deviations are: 14.21% for Anita Computer and 8.27% for index,
respectively.
COV1,M 15.33
B VarM .2244
1 68.33
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14. (a). The security market line (SML) shows the required return for a given level of systematic
risk. The SML is described by a line drawn from the risk-free rate: expected return is 5
percent, where beta equals 0 through the market return; expected return is 10 percent,
where beta equal 1.0.
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12% *Stock Y
10% *Market
9% *Stock Y
5%
14(b). The expected risk-return relationship of individual securities may deviate from that
suggested by the SML, and that difference is the asset’s alpha. Alpha is the difference
between the expected (estimated) rate of return for a stock and its required rate of return
based on its systematic risk Alpha is computed as
where
Calculation of alphas:
In this instance, the alphas are equal and both are positive, so one does not dominate the
other.
Another approach is to calculate a required return for each stock and then subtract that
required return from a given expected return. The formula for required return (k) is
k = rf + i (rM - rf ).
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14(c). By increasing the risk-free rate from 5 percent to 7 percent and leaving all other factors
unchanged, the slope of the SML flattens and the expected return per unit of incremental
risk becomes less. Using the formula for alpha, the alpha of Stock X increases to 1.1
percent and the alpha of Stock Y falls to -0.1 percent. In this situation, the expected
return (12.0 percent) of Stock X exceeds its required return (10.9 percent) based on the
CAPM. Therefore, Stock X’s alpha (1.1 percent) is positive. For Stock Y, its expected
return (9.0 percent) is below its required return (9.1 percent) based on the CAPM.
Therefore, Stock Y’s alpha (-0.1 percent) is negative. Stock X is preferable to Stock Y
under these circumstances.
Calculations of revised alphas:
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ii. Analyst estimate plot. Using the analyst’s estimates, Stock A plots below the
SML and Stock B, above the SML.
*Stock A
14.5% *Stock B
4.5%
0.8 1.2
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The beta for using the proxy is given by Cov(i,proxy)/Var(proxy). Given the data,
The proxy is not mean-variance efficient, as it is dominated by the true market portfolio.
17.17.
R
.18
.16
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.09
.07
1.0 Beta
It would be more difficult to show superior performance relative to the true market index.
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19. R
0.08
0.06
1.0 Beta
19(b). = Cov
i,m/(m)
2
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