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Ch 6 Solutions Rev CF2.feb067 - Risk and Return The CAPM...

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Risk and Return: The CAPM and Beyond 67 Chapter 6: Risk and Return: The CAPM and Beyond Answers to questions 6-1. The feasible set represents all possible combinations of risky assets. The efficient set represents only those combinations that maximize expected return for a given level of risk ( i.e ., for a given standard deviation). 6-2. When we looked at two-asset portfolios in Chapter 5, we saw that the relationship between a portfolio’s expected return and its standard deviation is nonlinear except in the special case that the correlation coefficient between the two assets is 1.0. In just about every real-world situation, the correlation between a pair of risky assets will be less than 1.0. That means that on a graph plotting a portfolio’s expected return and its standard deviation, the line connecting any two assets, or any two portfolios of assets, will generally be curved rather than straight. 6-3. No. Efficient portfolios maximize the expected return for any level of risk (standard deviation). This is not always the same thing as minimizing the level of risk (standard deviation) for a given expected return. If you look at the boundary of the feasible set, you will see that it forms a backward bending arc. This entire arc satisfies the condition of minimizing risk for any expected return, but only the portfolios on the upward sloping portion of the arc are efficient portfolios. 6-4. If there are ONLY two risky assets to invest in, the one with the higher return and higher standard deviation will always be efficient. The one with the lower return and standard may or may not be efficient depending on its correlation with the other asset. The lower that correlation, the more likely it is that the curve connecting these two assets will bend back on itself (see Figure 5.5), and if that happens the asset with the lower return will not be efficient. 6-5. If the rate of inflation is negatively correlated with returns on stocks, and if these inflation- indexed bonds are positively correlated with inflation, then the bonds will be negatively correlated with stocks. This implies that the feasible set moves a little to the left because there are new opportunities to diversify that can lower the overall risk of a portfolio. 6-6. We have seen that the relationship between expected return and standard deviation is nonlinear when we hold different combinations of risky assets. However, when we look at combinations of risky and risk-free assets, the relationship becomes linear. That is because the risk-free asset has a zero standard deviation and a zero covariance with any risky asset. That has the effect of making the expected return / standard deviation relationship linear. 6-7. It may be true that a diversified stock portfolio, such as the S&P500, is unlikely to increase by 50% in a single year. However, if an investor is willing to hold a portfolio as volatile as a portfolio of tech stocks, then a higher expected return could be achieved by combining a more diversified portfolio with leverage.
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