Read the following 5 statements and decide which of them are TRUE: Select one or more:...

Read the following 5 statements and decide which of them are TRUE: Select one or more: a. In the CAPM it is assumed that the relationship between returns and Beta is non-linear. b. The beta of the market portfolio is 1 while the beta of the risk free investment is 0. c. The security market line shows that the expected return of an investment is given by the risk free rate plus a risk premium for its sensitivity to changes in the market return. d. Findings from portfolio diversification tell us, that systematic risk can be diversified given a negative correlation between assets. e. Beta is a measure for systematic risk. In the CAPM, only this type of risk will be compensated.

Solutions

Expert Solution

a. In the CAPM it is assumed that the relationship between returns and Beta is non-linear - TRUE

Expected Return = Risk free Rate + Beta * Market Premium

This is an equation of a straight line. From the above Equation of CAPM Model, it clearly depicts that Beta and Expected Return are having a linear relationship.

b. The beta of the market portfolio is 1 while the beta of the risk-free investment is 0. - TRUE

Yes in the CAPM model we always compare any stocks/assets return with respect to Market portfolios return. That's why it is always assumed Beta of Market is 01. Risk-free rate having zero volatility leading to zero beta.

c. The security market line shows that the expected return of an investment is given by the risk free rate plus a risk premium for its sensitivity to changes in the market return. - TRUE

The equation for Security market line as follows :

SML : E(R) = R(f) + beta[ER(M) - R(f)]

R(f) = Risk Free Rate

Here beta [ER(M) - R(f)] = Risk Premium

Risk Premium changes with change in market return ER(M).

d. Findings from portfolio diversification tell us, that systematic risk can be diversified given a negative correlation between assets. - FALSE

Systematic Risk: Risks are due to the system i.e market. This type of risk is not diversifiable. Because we can not change/modify market volatility, economic scenario, etc.

Un-Systematic Risk: Unsystematic risks are risks that arise from the stock itself. This type of risk can be mitigated by proper portfolio diversification.

e. Beta is a measure for systematic risk. In the CAPM, only this type of risk will be compensated. - FALSE

Beta is a measure for a stock's risk. So it a measure of Un-Systematic Risk.

jeff jeffy answered 1 year ago

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