What is theCapital Market Line (CML), how is it related toefficient portfolios, and how does it interface withan investor’s indifference curve to determine the nvestor’s optimal portfolio? Is it possible that tworational investors could agree as to the specifications of the Capital Market Line, but one wouldhold a portfolio heavily weighted with Treasurysecurities while the other held only risky stocksbought on margin?

What is theCapital Market Line (CML), how is it related toefficient portfolios, and how does it interface withan investor’s indifference curve to determine the nvestor’s optimal portfolio? Is it possible that tworational investors could agree as to the specifications of the Capital Market Line, but one wouldhold a portfolio heavily weighted with Treasurysecurities while the other held only risky stocksbought on margin?

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter6: Risk And Return

Section: Chapter Questions

Problem 12MC: Calculate the correlation coefficient between Blandy and the market. Use this and the previously...

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You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Construct a plausible graph that shows risk (as measured by portfolio standard deviation) on the x-axis and expected rate of return on the y-axis. Now add an illustrative feasible (or attainable) set of portfolios and show what portion of the feasible set is efficient. What makes a particular portfolio efficient? Don’t worry about specific values when constructing the graph—merely illustrate how things look with “reasonable” data.
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Write out the equation for the Capital Market Line (CML), and draw it on the graph. Interpret the plotted CML. Now add a set of indifference curves and illustrate how an investor’s optimal portfolio is some combination of the risky portfolio and the risk-free asset. What is the composition of the risky portfolio?
Calculate the correlation coefficient between Blandy and the market. Use this and the previously calculated (or given) standard deviations of Blandy and the market to estimate Blandy’s beta. Does Blandy contribute more or less risk to a well-diversified portfolio than does the average stock? Use the SML to estimate Blandy’s required return.
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: What is the Capital Asset Pricing Model (CAPM)? What are the assumptions that underlie the model? What is the Security Market Line (SML)?
Which of the following is TRUE? To construct a capital market line, we use expected return as y-axis and beta as x-axis On the capital market line debt securities are located to the right of the market portfolio To construct a security market line, we use expected return as y-axis and beta as x-axis Market portfolio lays at an intersection of the average indifference curve of a risk-averse investor and the efficient portfolio
Which of the following statements is true regarding the optimal risky portfolio: It is designated by the point of tangency with iso-utility curve and the capital allocation line. It is designated by the point of highest Sharpe ratio in the opportunity set. It is designed by the point of tangency with the opportunity set and the securities market line. This portfolio gives the highest standard deviation risk per unit of risk premium in the opportunity set.
Which of the following statements is CORRECT? a. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. b. An investor can eliminate almost all risk if he or she holds a very large and well diversified portfolio of stocks. c. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. d. An investor can eliminate almost all diversifiable risk if he or she holds a very large, well-diversified portfolio of stocks. e. An investor can eliminate almost all market risk if he or she holds a very large and well diversified portfolio of stocks.
Which of the following statements about the minimum-variance portfolio of all risky securities is valid? (Assume short sales are allowed.) Explain.a. Its variance must be lower than those of all other securities or portfolios.b. Its expected return can be lower than the risk-free rate.c. It may be the optimal risky portfolio.d. It must include all individual securities.
“If markets are semistrong-form efficient, investors would only adopt passiveinvestment strategies and buy into an index fund, rather than active strategies wherethey would have a portfolio manager select the components of their portfolios andseek for mispriced equities.” Explain if true or not
An investor is trying to decide between Portfolio ST and Portfolio BT. Portfolio ST comprises of stocksfrom the tech, financial and construction industry, while Portfolio BT includes stock from tech and financial industries only. The table below contains information on both portfolios. Which portfolio is the optimal portfolio considering the threshold level? Why do you think portfolio BT has a higher standard deviation than portfolio ST?
Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolio performance, indicated that it may not be possible to evaluate portfolio management ability if there is an error in the benchmark used.a. In evaluating portfolio performance, describe the general procedure, with emphasis on the benchmark employed.b. Explain what Roll meant by benchmark error and identify the specific problem with this benchmark.c. Draw a graph that shows how a portfolio that has been judged as superior relative to a “measured” security market line (SML) can be inferior relative to the “true” SML.d. Assume that you are informed that a given portfolio manager has been evaluated as superior when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index. Explain whether this consensus would make you feel more comfortable regarding the portfolio manager’s true ability.e. Although conceding the possible problem with benchmark errors as set forth…
What should be the risk premium and return on a stock with a Beta of zero under the Capital Asset Pricing Model (CAPM)? What about the risk premium and return on a stock with a Beta of 1? In a world of certainty, investors will always invest in the asset with the highest return. In the real world, investors hold a diversified portfolio of securities. Why is this the case? Theoretically, returns on stocks or assets can be negatively correlated. In the real world, however, we usually encounter only positive correlations. Whymay this be the case?