Question

1. Portfolio theory defines risky investments in 2 ways expected returns and variance ( Standard deviation) of expected returns. What assumptions need to be made about investors and the expected investment returns in this 2 factor approach and state if they are justified in real life.

2. What can be said about the portfolio that is represented by any point along the efficient frontier of risky investment portfolios?

3. What is meant by two fund separation? 4. The capital asset pricing model tells us that a security with a beta of 2 will be expected to yield a return twice that of a security whose beta is 1. Is this statement true?

Answer 1

1. Portfolio theory of Markowitz defines risky investment for investors in two ways . and the assumptions for it are,

1. Investors are rational and they behave in a manner as that to maximize their return on the given income.
2. Investors have free access to all information
3. The market absorbs information quickly
4. Investors are risk sensitive and thus they try to minimize the risk and maximize the return’
5. Investors chose higher return to lower return on the same level of risk

2. The efficient frontiers are the group of optimal portfolios that offers high return on the same level or lower level of risk. So portfolio that lies on any point along the efficient frontier are those portfolios that offer higher return on assured risk.
3. Two fund separation theorems is by Markowitz that tells us that risk return pair of any feasible portfolio cannot lie above the Capital market line (CML), which is obtained by combining the risk free asset and the portfolio that maximizes the Sharpe Ration.
4. True.

Beta is the measure of risk by investing in a portfolio. CAPM shows that expected return is equal to the risk free return plus risk premium, which is based on beta of that security. So if the is beta is high then the return would be higher too.