Question

2. Please comment the following statement (30 marks) 1) The expected return of zero beta security is smaller than risk free rate. (5 marks) 2) According to CAPM, the higher the variance, the higher the expected return. (5 marks) 3) As diversification increases, the systematic risk of a portfolio approaches zero. (5 marks) 4) Analysts may use regression analysis to estimate the index model for a stock. When doing so, the slope of the regression line is an estimate of the beta of the asset. (5 marks) 5) According to the separation property, the determination of the optimal risky portfolio depends on personal preference. (5 marks) 6) A less risk-averse investor has a steeper indifference curve for the utility function. (5 marks)

Answer 1

1) The expected return of a zero-beta security should be equal to the risk-free rate because required rate is equal to

risk free rate + beta*Market risk premium.

If beta is zero then the required rate is equal to the risk-free rate not less than that.

2) In CAPM model the measure of risk in not variance, it is beta so higher the beta higher would be risk premium on that security and higher should be the expected return from that security.

3) There are two types of risk, systematic risk and nonsystematic risk. When you diversify your portfolio the non-systematic is diversified and eliminated or approaches zero. Systematic risk is the risk that is common across all securities and it cannot be diversified away.

4) Analyst may use the regression line to estimate the index model for a stock and in doing so the slope of the regression line is an estimate of the beta. Slope measure the change here.

5) According to the separation theory the determination of the optimal portfolio is not entirely dependent on personal preference. Determination of optimal portfolio is purely technical and how the asset is allocated to treasury bills or risky portfolio this depends on personal preference.

6) A more risk averse investor would have a steeper indifference curve for the utility function than the less risk averse investor, not the other way around.