Chapter 2: Q15I. (page 226)
If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.
The correct answer would be: “Not Possible”
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You manage an equity fund with an expected risk premium of 10% and a standard deviation of 14%. The rate on Treasury bills is 6%. Your client chooses to invest \(60,000 of her portfolio in your equity fund and \)40,000 in a T-bill money market fund. What is the expected return and standard deviation of return on your client’s portfolio?
Question: Don Sampson begins a meeting with his financial adviser by outlining his investment philosophy as shown below:
Statement Number | Statement |
1 | Investments should offer strong return potential but with very limited risk. I prefer to be conservative and to minimize losses, even if I miss out on substantial growth opportunities. |
2 | All nongovernmental investments should be in industry-leading and financially strong companies. |
3 | Income needs should be met entirely through interest income and cash dividends. All equity securities held should pay cash dividends. |
4 | Investment decisions should be based primarily on consensus forecasts of general economic conditions and company-specific growth. |
5 | If an investment falls below the purchase price, that security should be retained until it returns to its original cost. Conversely, I prefer to take quick profits on successful investments. |
6 | I will direct the purchase of investments, including derivative securities, periodically. These aggressive investments result from personal research and may not prove consistent with my investment policy. I have not kept records on the performance of similar past investments, but I have had some “big winners.” |
Select the statement from the table above that best illustrates each of the following behavioral finance concepts. Justify your selection.
i. Mental accounting.
ii. Overconfidence (illusion of control).
iii. Reference dependence (framing).
If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.
Shares of small firms with thinly traded stocks tend to show positive CAPM alphas. Is this a violation of the efficient market hypothesis?
In forming a portfolio of two risky assets, what must be true of the correlation coefficient between their returns if there are to be gains from diversification? Explain.
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