End of Chapter 6 Questions, Problems and Solutions
CORPORATE FINANCE
Professor Megginson
February 27, 2003
Questions [See problems in book]
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Answers to End of Chapter 6 Questions
61)
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).
62)
When we looked at twoasset 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 realworld 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.
63)
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.
64) In a world with just two risky assets, the one that has higher expected return and higher standard
deviation will always be efficient.
However, the asset that has a lower expected return and a lower
standard deviation may be efficient or inefficient, depending on the correlation coefficient between the
two assets.
If this coefficient is sufficiently low, then it may be possible to simultaneously increase the
portfolio’s expected return AND decrease its standard deviation by holding less than 100% of the low
risk, lowreturn asset.
In that case, the asset would not be efficient if held in isolation.
65) If the rate of inflation is negatively correlated with returns on stocks, and if these inflationindexed
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.
66) 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
riskfree assets, the relationship becomes linear.
That is because the riskfree asset has a zero standard
deviation and a zero covariance with any risky asset.
That has the effect of making the expected return /
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 Spring '07
 Harold
 Finance, Standard Deviation, Capital Asset Pricing Model, Corporate Finance, Intel, Modern portfolio theory

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