Question

5. Which of the following statements is CORRECT?

a. The CAPM has been thoroughly tested, and the theory has been confirmed beyond any

    reasonable doubt.

b. A graph of the SML as applied to individual stocks would show on beta the vertical axis and    

    required rates of return on the horizontal axis.

c. If two "normal" or "typical" stocks were combined to form a 2-stock portfolio, the

    portfolio's expected return would be a weighted average of the stocks' expected returns, but

   the portfolio's standard deviation would probably be greater than the average of the stocks'

   standard deviations.

d. If investors become more risk averse, then (1) the slope of the SML would increase and (2)

   the required rate of return on low-beta stocks would increase by less than the required

   return on high-beta stocks.

e. An increase in expected inflation, combined with a constant real risk-free rate and a constant

    market risk premium, would lead to decreases in the required returns on a riskless

    asset and on an average stock, other things held constant.

Answer 1

a) The CAPM is a very famous model and has been thoroughly tested but is not beyond doubt. But its simplicity and effectiveness makes it one of the best models . So statement is incorrect

b) In SML graph , Beta is on horizontal axis and Return on Vertical axis. So statement is incorrect

c) The standard deviation of the portfolio of any two normal stocks shall be less than the stocks weighted average standard deviation. It is equal only when the correlation coefficient between the two is +1.So statement is incorrect

d) If investors are more risk averse, they shall not want to take risk and hence the market risk premium would increase leading to increase in the slope of SML. Also,for low beta stocks, the required return as calculated by CAPM shall increase by less amount than for stocks with high beta. The difference shall be directly proportional to Beta. So statement is correct

e) Increase in expected inflation with constant real risk free rate will increase the nominal risk free rate as well as the stock's required rate of return and hence would result in higher required return on a riskless asset and stock. So statement is incorrect