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Unformatted text preview: Chapter 9: Asset Pricing Models ANSWERS TO END-OF-CHAPTER QUESTIONS 9-1. Lending possibilities change part of the Markowitz efficient frontier from an arc to a straight line. The straight line extends from RF, the risk-free rate of return, to M, the market portfolio. This new opportunity set, which dominates the old Markowitz efficient frontier, provides investors with various combinations of the risky asset portfolio M and the riskless asset. Borrowing possibilities complete the transformation of the Markowitz efficient frontier into a straight line extending from RF through M and beyond. Investors can use borrowed funds to lever their portfolio position beyond point M, increasing the expected return and risk beyond that available at point M. 9-2. Under the CAPM, all investors hold the market portfolio because it is the optimal risky portfolio. Because it produces the highest attainable return for any given risk level, all rational investors will seek to be on the straight line tangent to the efficient set at the steepest point, which is the market portfolio. 9-3. The basic difference between graphs of the SML and the CML is the label on the horizontal axis . For the CML, it is standard deviation while for the SML, beta. Also, the CML is applicable to portfolios while the SML applies to individual securities and to portfolios. 9-4. In theory, the market portfolio (portfolio M) is the portfolio of all risky assets, both financial and real, in their proper proportions. Such a portfolio would be completely diversified; however, it is a risky portfolio. In equilibrium, all risky assets must be in portfolio M because all investors are assumed to hold the same risky portfolio. If they do, in equilibrium this portfolio must be the market portfolio consisting of all risky assets. 9-5. The slope of the CML is ER M- RF SD M where ER M is the expected return on the market M portfolio, RF is the rate of return on the risk-free asset, and SD M is the standard deviation of the returns on the market portfolio. The slope of the CML is the market price of risk for efficient portfolios; that is, it indicates the equilibrium price of risk in the market. It shows the additional return that the market demands for each percentage increase in a portfolio's risk. 9-6. The CML extends from RF, the risk-free asset, through M, the market portfolio of all risky securities (weighted by their respective market values). This portfolio is efficient, and the CML consists of combinations of this portfolio and the risk-free asset. All asset combinations on the CML are efficient portfolios consisting of M and the risk-free asset. 9-7. The contribution of each security to the standard deviation of the market portfolio depends on the size of its covariance with the market portfolio. Therefore, investors consider the relevant measure of risk for a security to be its covariance with the market portfolio....
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- Spring '11