272354
Description
Flashcards by Nafisa Zahra, updated more than 1 year ago
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Created by Nafisa Zahra
about 11 years ago
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| Question | Answer |
| Two investment advisers are comparing performance. One averaged a 19% rate of return and the other a 16% rate of return. However, the beta of the first investor was 1.5 whereas that of the second was 1. Which investor was the better selector of stocks? | To determine which investor was a better selector of individual stocks we look at abnormal return, which is the ex-post alpha; that is, the abnormal return is the 21. a. Here, not only does the second investor appear to be the superior stock selector, but the first investor’s predictions appear valueless (or worse). Since the market portfolio, by definition, has a beta of 1, its expected rate of return is 12%. difference between the actual return and that predicted by the SML. Without information about the parameters of this equation (risk-free rate and market rate of return) we cannot determine which investor was more accurate |
| How can we tell which investor is the superior stock selector | Using parameters of SML we isolate alpha. The one which has the more positive alpha is the better stock selector. |
| We're comparing two portfolios with the same beta. However, the specific risk for each individual security in each is higher for one portfolio than another. From which portfolio should investors expect a higher return from? | Under the CAPM, the only risk that investors are compensated for bearing is the risk that cannot be diversified away (systematic risk). Because systematic risk (measured by beta) is equal to 1.0 for both portfolios, an investor would expect the same rate of return from both portfolios A and B. Moreover, since both portfolios are well diversified, it doesn’t matter if the specific risk of the individual securities is high or low. The firm-specific risk has been diversified away for both portfolios. |
| Identify and briefly discuss three criticisms of beta | i) Betas are estimated with respect to market indexes that are proxies for the true market portfolio, which is inherently unobservable. (ii) Empirical tests of the CAPM show that average returns are not related to beta in the manner predicted by the theory. The empirical SML is flatter than the theoretical one. (iii) Multi-factor models of security returns show that beta, which is a one-dimensional measure of risk, may not capture the true risk of the stock of portfolio. |
| What are the likely effects of an incorrectly specified market proxy on both beta and the slop of the SML | 3. The effect of an incorrectly specified market proxy is that the beta of Black’s portfolio is likely to be underestimated (i.e., too low) relative to the beta calculated based on the “true” market portfolio. This is because the Dow Jones Industrial Average (DJIA) and other market proxies are likely to have less diversification and therefore a higher variance of returns than the “true” market portfolio as specified by the capital asset pricing model. Consequently, beta computed using an overstated variance will be underestimated. This result is clear from the following formula: β = Cov(rPortfolio , rMarket Proxy ) Portfolio σ 2 Market Proxy An incorrectly specified market proxy is likely to produce a slope for the security market line (i.e., the market risk premium) that is underestimated relative to the “true” market portfolio. This results from the fact that the “true” market portfolio is likely to be more efficient (plotting on a higher return point for the same risk) than the DJIA and similarly misspecified market proxies. Consequently, the proxy-based SML would offer less expected return per unit of risk. |
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