Chapter 5
Risk and Return:
Portfolio Theory and Asset Pricing
Models
ANSWERS TO END-OF-CHAPTER QUESTIONS
5-1
a.
A portfolio is made up of a group of individual assets held in combination.
An asset
that would be relatively risky if held in isolation may have little, or even no risk if
held in a well-diversified portfolio.
The feasible, or attainable, set represents all portfolios that can be constructed from
a given set of stocks.
This set is only efficient for part of its combinations.
An efficient portfolio is that portfolio which provides the highest expected return for
any degree of risk.
Alternatively, the efficient portfolio is that which provides the
lowest degree of risk for any expected return.
The efficient frontier is the set of efficient portfolios out of the full set of potential
portfolios.
On a graph, the efficient frontier constitutes the boundary line of the set
of potential portfolios.
b.
An indifference curve is the risk/return trade-off function for a particular investor
and reflects that investor's attitude toward risk. The indifference curve specifies an
investor's required rate of return for a given level of risk.
The greater the slope of
the indifference curve, the greater is the investor's risk aversion.
The optimal portfolio for an investor is the point at which the efficient set of
portfolios--the efficient frontier--is just tangent to the investor's indifference curve.
This point marks the highest level of satisfaction an investor can attain given the set
of potential portfolios.
c.
The Capital Asset Pricing Model (CAPM) is a general equilibrium market model
developed to analyze the relationship between risk and required rates of return on
assets when they are held in well-diversified portfolios.
The SML is part of the
CAPM.
The Capital Market Line (CML) specifies the efficient set of portfolios an investor
can attain by combining a risk-free asset and the risky market portfolio M.
The
CML states that the expected return on any efficient portfolio is equal to the riskless
rate plus a risk premium, and thus describes a linear relationship between expected
return and risk.
d.
The characteristic line for a particular stock is obtained by regressing the historical
Answers and Solutions:
5 - 1

returns on that stock against the historical returns on the general stock market.
The
slope of the characteristic line is the stock's beta, which measures the amount by
which the stock's expected return increases for a given increase in the expected
return on the market.
The beta coefficient (b) is a measure of a stock's market risk.
It measures the stock's
volatility relative to an average stock, which has a beta of 1.0.
e.
Arbitrage Pricing Theory (APT) is an approach to measuring the equilibrium
risk/return relationship for a given stock as a function of multiple factors, rather than
the single factor (the market return) used by the CAPM.
The APT is based on
complex mathematical and statistical theory, but can account for several factors

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