Question 1

What is true about the risk free rate?
A)The risk free rate represents the interest an investor would expect from an absolutely risk free investment over a specified period of time.
B)The risk free rate is the minimum return that an investor expects for any investment. A rational investor will not accept any additional risk unless the potential rate of return is greater than the risk free rate.
C)The risk-free rate does not truly exist because even the safest investments carry a very small amount of risk.
D)All of the above.

Accepted Answer

The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. In theory, it is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate.
Key Takeaway: In practice, the U.S. Treasury Bill is generally considered the risk-free alternative to any investment. For project based finance, one would typically use the rate of return for the T-bill with a similar length of investment. So if a project returns over 10 years, one would use the 10 year T-bill in the calculations.

Question 2

According to the CAPM model: Expected Return = Risk free rate + Risk premium. For investors like David, the model compensates the time value of his money and risk when he invests into any investment over a period of time. What does the risk free rate compensate David for?
A)The time value of his money.
B)The risk he takes.
C)Both the time value of his money and the risk he takes.
D)None

Accepted Answer

The CAPM compensates investors for the time value of their money. In theory, the risk free interest rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate.
Key Takeaway: In practice, risk free rate does not exist because even the safest investments carry a very small amount of risk. Therefore, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate.

Question 3

Beta provides a measure of the "systematic risk" of the portfolio. This is the part of the risk that cannot be diversified away. Given that the portfolio risk is measured by its covariance, why are investors still willing to hold assets with lower expected returns?
A)Assets with low expected returns now can yield higher returns in the future.
B)Investors do not have any other better alternatives.
C)Although these assets have low expected returns, they are less risky due to low overall systematic risk.
D)Low expected returns attract less investors, so it is difficult to sell them.

Accepted Answer

Although these assets have low expected returns, the low betas means together they can considerably reduce overall systematic risk. The ? of an asset measures its relative impact on the systematic risk of the portfolio as a proportion of the total variance of the portfolio. Assets therefore with low betas are willingly held despite their low expected returns because they considerably reduce overall undiversifiable (systematic) risk in equilibrium.
Key Takeaway: In short, adding a lower return asset can improve the portfolio's risk profile.

Question 4

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. However the CAPM model only compensates investors for taking systematic risk, not specific risk. Why is this the case?
A)Because the CAPM favors systematic risk.
B)Because systematic is diversifiable, while specific risk is undiversifiable.
C)Because systematic is undiversifiable, while specific risk is diversifiable.
D)Because investors only accept systematic risk, not specific risk.

Accepted Answer

Systematic is undiversifiable, while specific risk is diversifiable. Investors are exposed to both risks but since specific risk is diversified away, the investors' net exposure is just systematic risk.
Key Takeaway: The CAPM formula is: Expected Return = Risk free rate + beta*(Market return -risk-free rate). Systematic risk can be measured using beta. Given a beta and an expected return for an asset, investors will bid its current price up or down, adjusting that expected return so that it satisfies the CAPM formula.

Question 5

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. What is the difference between systematic risk and specific risk?
A)Systematic risk is the risk of holding the market portfolio and specific risk is the risk which is unique to an individual asset.
B)Both risks correlate with movements in the market.
C)Systematic risk can be diversified away while specific risk cannot be.
D)There is no difference between them.

Accepted Answer

Systematic risk is the risk of holding the market portfolio and specific risk is the risk unique to an individual asset. While systematic risk correlates with movements in the market, specific risk is uncorrelated with the market's movements.
Key Takeaway: Because systematic risk is a risk of an entire market, it cannot be diversified away, while specific risk can be. Diversification helps an investor reduce market risk simply by investing in many unrelated assets that do not have correlated specific risk.

Question 6

Beta β is the measure of systematic risk and it can be applied to market timing. Consider the following situation: Mike is an investor and he expects that the market will go down. How should he react to the expectation?
A)He wants to move into higher beta stocks.
B)He wants less exposure to the stock market and hence should buy stocks with lower betas.
C)He will not do anything because the market will go up and it will not affect his situation.
D)He will not invest anymore because he loses confidence in the market.

Accepted Answer

When the market is expected to go down, Mike would want less exposure to the stock market, so he should buy stocks with lower systematic risks, or lower beta. Lower systematic risk means lower risk associated with aggregate market returns.
Key Takeaway: Systematic risk is the risk associated with aggregate market returns. Systematic risk cannot be reduced through diversification. This of course is a theoretical question to illustrate a point, as most stocks have systematic risk. If Mike thinks the market is going down for sure, he should probably get out of equities altogether.

Question 7

What of the following assumptions is NOT true when conducting analysis using CAPM model?
A)Market is frictional.
B)Expectations are homogeneous.
C)Investors hold risky assets in the same proportions. Their CML is the same and they all have market portfolio M.
D)Market is in equilibrium.

Accepted Answer

In the CAPM analysis framework, the assumption is that the market is frictionless. Thus, it assumes there are no transaction costs, taxes, or holding constraints. This will allow free market transactions.
Key Takeaway: This assumption is unrealistic and is relaxed by adding another term to the CAPM. When adding another term to CAPM model, the analysis depends on the tax parameters since investors face taxes on dividends or capital gains of different types.

Question 8

In finance, the beta of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole. When an asset has a beta value of 0, which of the following is true?
A)The asset's price is not at all correlated with the market or the asset is independent of market.
B)The asset generally follows the market.
C)The asset inversely follows the market, but it generally decreases in value if the market goes up and vice versa.
D)None of the above is true.

Accepted Answer

When an asset has a beta value of 0, its price is not at all correlated with the market. Rather, the asset is independent of market. The beta coefficient is a key parameter in the CAPM. It is a measure of the volatility (or systematic risk) of a security or a portfolio in comparison to the market as a whole. This is the part of the risk that cannot be diversified away. Beta can be estimated for individual companies using regression analysis against a stock market index.
Key Takeaway: Any investment that does not correlate with an index such as the Dow Jones Industrial Average (DJIA) or overall market results is a zero-beta asset.

Question 9

Alpha is a risk-adjusted measure of the active return on an investment. It is a return in excess of the compensation for the risk occurred and thus, commonly used to assess active managers' performances. The higher the alpha,...
A)The worse the manager.
B)The better the manager.
C)The same the manager.
D)The more risk.

Accepted Answer

The higher the 'alpha,' the better the manager. Alpha represents the fund's return when the benchmark's return is 0. This shows the fund's performance relative to the benchmark and can show how the fund manager performs.
Key Takeaway: Alpha is a parameter in the CAPM. The expected value of the alpha equals the return of the risk free asset. If alpha is smaller than the risk free rate, the investment is too risky for the return. If alpha equals the risk free rate, the investment has earned a return adequate for the risk taken. If alpha is higher than the risk free rate, the investment has higher reward for the assumed risk.

Question 10

According to the CAPM, portfolios may randomly outperform or underperform the market from one year to the next. However, when portfolios consistently outperform the market over the years, which of the following is NOT true about alpha?
A)Alpha is the difference in the expected returns of the portfolio that is performing well over the years and that of the market portfolio.
B)Alpha shows a persistent positive contribution to a portfolio's expected return due to the manager's skill.
C)Alpha cannot be negative.
D)If alpha is positive, it means that investment portfolios outperform the market portfolio. If alpha is negative, it means that investment portfolios underperform the market portfolio.
E) All of the above.

Accepted Answer

Alpha can be negative. A, B and D are all true.
Key Takeaway: Empirical evidence shows that investment managers rarely have a positive alpha. Michael Jensen (1968) was the one who defined alpha and conducted research to calculate some mutual funds' alphas and saw if they were positive. The result showed that the vast majority of the funds had negative estimated alpha.

Question 11

The Volatility Index (VIX) is the most popular measure of stock market volatility. Mike is an investor and despite the fact that the VIX is high, he still decides to buy stocks. He makes that decision because
A)The VIX history shows that he should do so.
B)His own intuition tells him to do so.
C)His personal savings allows him to do so.
D)He has nothing else do to.

Accepted Answer

The history of VIX has shown that when the index is high, it is time to buy stocks. Over the years, the index soared after major events, such as the Asian Crisis in 1997 or the collapse of the LTCM hedge fun in 1998. These events caused such a loss in public confidence in the market that stock prices fell, even when volatility decreased. After a while, the market regained its confidence and stocks rose again. So buying stocks when VIX is high promises returns in the future.
Key Takeaway: When Mike makes the decision to buy stocks even when the stock market volatility is high, he makes the assumption that it is only a short phase and everything will return to normal. It is a gamble since a crisis can last for a long time and the confidence is hard to recover.

Question 12

Britney is a trader and she holds her portfolio of commodity forwards. She knows what the market value is today, but she is uncertain about its market value a week from today. What does it mean?
A)Britney faces market risk.
B)Since market value is unpredictable, Britney should not hold the portfolio but should sell it soon.
C)Britney's uncertainty can be managed by long term focus with careful planning and investment.
D)Her trading activity is agreed to by a contract so she doesn't face any risk in the future.

Accepted Answer

Britney faces market risk which is exposure to uncertain market value of a portfolio.
Key Takeaway: Market risk reduces the value of an investment due to the fluctuations in the market. There are four standard risk factors: equity risk, currency risk, commodity risk, and interest rate risk.

Quiz 7: The Capital Asset Pricing Model

What is true about the risk free rate?

According to the CAPM model: Expected Return = Risk free rate + Risk premium. For investors like David, the model compensates the time value of his money and risk when he invests into any investment over a period of time. What does the risk free rate compensate David for?

Beta provides a measure of the "systematic risk" of the portfolio. This is the part of the risk that cannot be diversified away. Given that the portfolio risk is measured by its covariance, why are investors still willing to hold assets with lower expected returns?

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. However the CAPM model only compensates investors for taking systematic risk, not specific risk. Why is this the case?

The CAPM decomposes a portfolio's risk into systematic risk and specific risk. What is the difference between systematic risk and specific risk?

Beta β is the measure of systematic risk and it can be applied to market timing. Consider the following situation: Mike is an investor and he expects that the market will go down. How should he react to the expectation?

What of the following assumptions is NOT true when conducting analysis using CAPM model?

In finance, the beta of a stock or portfolio is a number describing the relation of its returns with that of the financial market as a whole. When an asset has a beta value of 0, which of the following is true?

Alpha is a risk-adjusted measure of the active return on an investment. It is a return in excess of the compensation for the risk occurred and thus, commonly used to assess active managers' performances. The higher the alpha,...

According to the CAPM, portfolios may randomly outperform or underperform the market from one year to the next. However, when portfolios consistently outperform the market over the years, which of the following is NOT true about alpha?

The Volatility Index (VIX) is the most popular measure of stock market volatility. Mike is an investor and despite the fact that the VIX is high, he still decides to buy stocks. He makes that decision because

Britney is a trader and she holds her portfolio of commodity forwards. She knows what the market value is today, but she is uncertain about its market value a week from today. What does it mean?