Question

Parts a,b,c

Only bullet points needed on what I should write about thanks

Answer Question l and one other question. Question 1 is allocated 60% of the marks for the paper. The other question is allocated 40% of the marks for the paper. Questions 2 and 3 are graded as a whole The duration of the examination is 2 hours. . Answer four parts of the following question. Your answer for each part should be no longer than two pages long (a) Use the single index model to derive an econometric model of the capital asset pricing model. (b) With the aid of an example, show how the security market line differs from the capital market line? (c) A fully diversified portfolio will have no risk? True or false? Explain your answer (d) The standard deviation of the return on stock A is greater than that of stock B. This does not guarantee that the Beta for stock A is greater than the Beta for stock B. True or false? Explain you answer there is no idiosyncratic risk. Derive the arbitrage pricing theory (APT) model available (e) Assume for simplicity sake that one factor has been deemed appropriate to "explain" returns on stocks and (t) Describ e and graphically illustrate Markowitz' portfolio optimisation solution if a risk-free asset is not

Answer 1

(a)

• The CAPM (Capital Asset Pricing Model) is an equation derived using the Security Market line.
• For a given asset,only its price risk is relevant, which is measure using the covariance between an asset's returns and returns on the market. (Cov. i,m)
• Using Cov. i,m as a measure of the asset's systematic risk, we can plot the relation between risk and return for a given individual asset.
• The graph below demonstrates this relation.

• The most common way to describe the SLM is that it is the relation between beta (systematic risk) and expected return. This is also known as the Capital Asset Pricing Model (CAPM).
• This relation is depicted in the graph below:

• The equation of a linear line is represented as: Y = mx + c

(b)

• The CML is used to calculate a return using a risk-free portfolio and levels of risk for a give (risky) portfolio.
• The SML is a graphical representation (as we have have seen above) of the market's risk and return as any given time.
• The CML measures the total risk (Standard deviation) , whereas the SML measures the Systematic risk (Beta)
• The CML is applicable to only efficient portfolios. ( referring to the efficient frontier)
• The SML, and thus the CAPM can be applied for any given security.
• You may also include an example of how securities are graphed on the CML and SLM respectively, to visualise the differences.

(c)

• False. It is false that a diversified portfolio will have no risk.
• Total Risk = Systematic Risk + Unsystematic Risk.
• Adding diversification into your portfolio helps to reduce the unsystematic risk (unique/ firm specific risk) of an asset.
• Example of Unsystematic risk would be financial risk, business risk.
• Even though the unsystematic risk can be diversified away, what remains in the systematic risk of a portfolio.
• Systematic risk refers to the market risk, which is non-diversifiable and uncontrollable.