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Solutions to Concept Questions 5

Prof. Itamar Drechsler


1. What is the capital market line?
(a) It is the efficient frontier formed by the risk-free asset and the market portfolio
(b) It is the investment opportunity set formed by 2 risky assets and 1 riskless asset
(c) It is the straight line that gives the relationship between the expected excess
return on a security and the expected excess return on the market portfolio.
(d) It describes all optimal portfolios for one individual that are composed of the
market portfolio and the risk-free rate.
Answer: The correct answer is (a).
The efficient frontier in the case of several risky assets and one risk-free
asset is called the capital allocation line (CAL). The CAL is a straight
line through the risk-free return and the return of the tangency portfolio.
The CAPM tells us that the market portfolio is the tangency portfolio.
In that case, we call the line capital market line. Answer (d) is incorrect
because the capital market line is composed of efficient, not optimal,
portfolios.
2. What does the market price of risk measure?
(a) It measures the standard deviation of a portfolio which captures the amount of
risk an investor takes on
(b) It measures the risk premium for holding any risky security
(c) It measures the risk premium per unit of risk for holding the market portfolio.
(d) It measures the profitability of an asset, expressed as a function of its risk.
Answer: The correct answer is (c).
The Sharpe ratio of the market portfolio is called the market price of risk.
By definition, it is the expected excess return on the market portfolio
relative to its volatility. Hence, it is the risk premium per unit of risk.

3. The market capitalization of a stock measures:


(a)
(b)
(c)
(d)

the
the
the
the

number of oustanding shares


total book value of the company
stock price per share
number of shares times the price per share.

Answer: The correct answer is (d).


The number of shares times the price per share is the overall market
value of the assets. It is called the market capitalization of the stock.
4. Which of the following statements about the security market line (SML) is
false?
(a) The SML provides a benchmark for evaluating expected investment performance
of a security
(b) The SML leads all investors to invest in the same portfolio of assets
(c) The SML is a graphic representation of the relationship between expected returns
and beta
(d) Properly valued assets plot exactly on the SML
Answer: The correct answer is (b).
Answer (a) is correct since the security market line tells you what the
expected return of an asset is given its systematic risk measured by .
Hence, answer (c) is also correct. And because the price of an asset
determines the expected return, answer (d) is also correct.
5. The beta of a security measures
(a) How its return comoves with the market return
(b) How high the standard deviation of the security is
(c) The compensation for idiosyncratic risk when holding the security (quantity of
risk times price of risk)
(d) The compensation for systematic risk of the security when holding the security
(quantity of risk times price of risk)
Answer: The correct answer is (a).
measures the systematic component of risk and is defined as
=

Cov (Ri , Rm )
.
Var (Rm )

Answer (d) is wrong because only measures the quantity of risk. Only
when multiplied by the market risk premium (expected excess return on
the market) can you conclude what the compensation for systematic risk
is.
2

6. A stock with a negative beta


(a) has an expected return lower than the market return
(b) has an expected return that is negative
(c) has an expected return that is lower than the risk-free rate
(d) does not exist, all stocks must have positive beta.
Answer: The correct answer is (c).
Answer (c) is correct. The formula
E[Ri ] = Rf + i E[Rm Rf ]
tells us the answer.
7. According to the CAPM, any two securities must have
(a) the same expected excess return
(b) the same ratio of expected excess return to standard deviation of the market
portfolio
(c) the same ratio of expected excess return to risk contribution to the market portfolio
(d) the same beta
Answer: The correct answer is (c).
Different securities can have different betas. Reformulating the equation
in the previous answer tells us that the ratio
E[Ri ] Rf
= E[Rm Rf ]
i
has to be the same for all securities. This is the case because the righthand side, the expected excess return on the market portfolio, is the
same for all securities.

8. The CAPM asserts that expected returns on individual securities are best
explained by
(a) economic factors, such as covariance of returns with GDP growth
(b) idiosyncratic risk
(c) systematic risk, captured by covariance with the market return
(d) diversification
Answer: The correct answer is (c).
According to the CAPM, different betas explain all differences in expected returns across securities. As mentioned above, beta measures
the covariance of the asset with the market return. Hence answer (c) is
correct.
9. The security characteristic line is
(a) the straight line of all efficient portfolios that investors are confronted with in
equilibrium
(b) the straight line that links the expected excess return of a security to its beta.
(c) the straight line that we get from regressing the securitys actual excess return on
the actual market excess return.
(d) the investment opportunity set of the risk-free asset and the market portfolio.
Answer: The correct answer is (c).
The definition of the security characteristic line was given in the lecture.
Answer (c) is correct.
10. Suppose the expected market return is 14%, the volatility of the market is
.25, the risk-free rate is 4% and the beta of Yahoo is 3.3. What return does
the CAPM predict for Yahoo?
(a) E[RYahoo ] = 0.04 + (0.14 0.04)/0.25 3.3
(b) E[RYahoo ] = (0.14 0.04)/0.25 3.3
(c) E[RYahoo ] = (0.14/.25) 3.3
(d) E[RYahoo ] = 0.04 + (0.14 0.04) 3.3
Answer: The correct answer is (d).
see the equation in the answer to question 6.

11. Suppose the CAPM-predicted expected return on Yahoo is 37%, but when
you run a regression of the return of Yahoo on the market return, you find
that the data imply that the expected return ought to be 40%. Which
statement is correct?
(a) Yahoo has a negative alpha. It is overpriced compared to the CAPM.
(b) Yahoo has a negative alpha. It is underpriced compared to the CAPM.
(c) Yahoo has a positive alpha. It is overpriced compared to the CAPM.
(d) Yahoo has a positive alpha. It is underpriced compared to the CAPM.
Answer: The correct answer is (d).
Since the return that you find in the data is higher, must be positive.
The relationship is given by the regression equation
Ri Rf = i + i [Rm Rf ] + ei .
A higher return means that the price is lower. This inverse relationship
between prices and returns can be seen from the definition of returns
R=

P1 D1
1
P0

where P stands for the price of the asset in the corresponding period and
D for the dividend. A low price then means that the asset is underpriced.

12. You are the manager of a firm and have to decide whether or not to undertake the following project. The project has an internal rate of return
(IRR) of 10%. Your companys beta is 0.5, the expected market return is
.10 and the risk-free rate is zero. Which is the correct decision.
(a) Undertake the project because the IRR of the project is lower than the cost of
capital.
(b) Undertake the project because the IRR of the project is greater than the cost of
capital.
(c) Dont undertake the project because the cost of capital is greater than the IRR
of the project.
(d) Dont undertake the project because the cost of capital is lower than the IRR of
the project.
Answer: The correct answer is (b).
The cost of capital is the required rate of return that we use in the
calculation of the net present value. We can compute it for the project
i as
E[Ri ] = Rf + E[Rm Rf ] =

1
0.1 = 0.05 < IRR = 10%.
2

Since the cost of capital is lower than the internal rate of return, you
undertake the project. To put it differently, the project compensates you
enough in return for taking on the amount of systematic risk.