PracticeTest#3Solution - Finance 4329: Investment Analysis...

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Finance 4329: Investment Analysis and Portfolio Management Practice Test #3 – Lecture Notes Parts 7 and 8 Name:__________________________________________________ ESSAY QUESTIONS 1. Discuss the assumptions of the capital asset pricing model, and how these assumptions relate to the “real world” investment decision process. The assumptions are… (1) The market is composed of many small investors, who are price-takers (i.e., perfect competition). In reality this assumption was fairly realistic until recent years when institutional investors increasingly began to influence the market with their transactions, especially those transactions via program trading. Since the 1987 market crash, circuit breakers on program trading have been enacted and market volatility decreased somewhat, until the past few years when market volatility has risen sharply. (2) All investors have the same holding period. Obviously, different investors have different goals, and thus have different holding periods. (3) Investments are limited to those that are publicly traded. In addition, it is assumed that investors may borrow or lend any amount at a fixed, risk-free rate. Obviously, investors may purchase assets that are not publicly traded. However, the dollar volume of publicly traded assets is considerable. The assumption that investors can borrow or lend any amount at a fixed, risk-free rate is obviously false. However, the model can be modified to incorporate different borrowing and lending rates. (4) Investors pay no taxes on returns and incur no transaction costs. Obviously, investors do pay taxes and do incur transaction costs. The tax differentials across different types of investment income and across different income levels have been lessened as a result on the income tax simplification of 1986. Investors should consider after-tax, not before-tax, returns. In addition, any investment vehicle should stand on its own merits, not its tax status. Compared to other
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PracticeTest#3Solution - Finance 4329: Investment Analysis...

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