Question

True or false. If your answer is false, you must justify your answer with a one sentence explanation to receive any credit.

1. The theory of diversification says that we can eliminate unsystematic risk in an equity portfolio by holding a sufficient number of securities.

2. The CAPM predicts that a security with a beta of 0 will have an expected return of 0.

3. If asset A and asset B both have an expected return of .1, then any portfolio with positive weights on A and B (and no other investments) must also have an expected return of .1.

4. If we are comparing 2 securities trading on the New York Stock Exchange, the one with the lower beta will have the higher expected rate of return.

Answer 1

1. True. Unsystematic risk can be eliminated in an equity portfolio by diversification.

2. False. Beta denotes risk or variation (or responsiveness) of the security return in relation to market return. Beta varies from 0 to 1. When the beta of a security is 0,there is no risk involved or it is risk free. Hence, the security has a rate of return equal to the risk free rate and expected return cannot be 0.

3. True. The return on a portfolio is the weighted return of its individual assets. Hence, if both assets A & B, have the same return any combination of these assets would give the same weighted average return since the individual return is the same.

4. False. Beta denotes risk or variation (or responsiveness) of the security return in relation to market return. Lower beta denotes lower risk and since the risk is lower, the expected rate of return on that security is also lower while the security with a higher risk would have a higher expected rate of return. Risk and return are positively correlated as return is a reward for risk. Higher the risk, higher is the expectation of return.