University:
CFA Institute
Course:
CFA Program Level 1 | Portfolio Management and Wealth Planning
Academic year:

2023
Views:

24

Pages:

12
Author:

anon

CFA Level 1 - Portfolio Management Session 12 - Reading 45 (Notes, Practice Questions, Sample Questions) 1. Which of the following statements about asset pricing models is most accurate? A)Assuming assets are not perfectly positively correlated, the systematic risk of a portfolio decreases as more assets are added. B)According to the Capital Asset Pricing Model (CAPM), the expected rate of return of a portfolio with a beta of 1.0 is the market expected return. C)Adding the risk-free asset to a portfolio will reduce return and total risk. B — Diversification reduces unsystematic, or unique risk. With the risk-free asset and a portfolio of risky assets, the equation for the expected standard deviation is linear: wAsA . A combination of the risk free asset and a portfolio always gives more return for a given level of risk.Risk tends to be reduced, but assuming that assets are not perfectly positively correlated, an investor can achieve the benefits of diversification by adding just one security (Markowitz). Studies have shown that approximately 18-30 stocks are needed for proper diversification. The main point is that the number of stocks required is small and is significantly less than all securities (and significantly less than 1,000 securities) 2. An equally weighted portfolio of a risky asset and a risk-free asset will exhibit: A)more than half the returns standard deviation of the risky asset. B)less than half the returns standard deviation of the risky asset. C)half the returns standard deviation of the risky asset. C — A risk free asset has a standard deviation of returns equal to zero and a correlation of returns with any risky asset also equal to zero. As a result, the standard deviation of returns of a portfolio of a risky asset and a risk-free asset is equal to the weight of the risky asset multiplied by its standard deviation of returns. For an equally weighted portfolio, the weight of the risky asset is 0.5 and the portfolio standard deviation is 0.5 × the standard deviation of returns of the risky asset 3. The slope of the capital market line (CML) is a measure of the level of: A)expected return over the level of inflation. B)risk over the level of excess return. C)excess return per unit of risk. C — The slope of the CML indicates the excess return (expected return less the risk-free rate) per unit of risk 4. Which of the following is the vertical axis intercept for the Capital Market Line (CML)? A)Expected return on the market. B)Risk-free rate. C)Expected return on the portfolio. B — The CML originates on the vertical axis from the point of the risk-free rate 5. According to capital market theory, which of the following represents the risky portfolio that should be held by all investors who desire to hold risky assets? A)The point of tangency between the capital market line (CML) and the efficient frontier. B)Any point on the efficient frontier and to the left of the point of tangency between the CML and the efficient frontier. C)Any point on the efficient frontier and to the right of the point of tangency between the CML and the efficient frontier A — Capital market theory suggests that all investors should invest in the same portfolio of risky assets, and this portfolio is located at the point of tangency of the CML and the efficient frontier of risky assets. Any point below the CML is suboptimal, and points above the CML are not feasible 6. All portfolios on the capital market line are: A)unrelated except that they all contain the risk-free asset. B)perfectly positively correlated. C)distinct from each other B — The introduction of a risk-free asset changes the Markowitz efficient frontier into a straight line. This straight efficient frontier line is called the capital market line (CML). Since the line is straight, the math implies that any two assets falling on this line will be perfectly, positively correlated with each other. Note: When ra,b = 1, then the equation for risk changes to sport = WAsA + WBsB, which is a straight line 7. The beta of Stock A is 1.3. If the expected return of the market is 12%, and the risk-free rate of return is 6%, what is the expected return of Stock A? A)14.2%. B)15.6%. C)13.8%. C — RRStock = Rf + (RMarket - Rf) × BetaStock, where RR= required return, R = return, and Rf = risk-free rate Here, RRStock = 6 + (12 - 6) × 1.3 = 6 + 7.8 = 13.8% 8. The beta of stock D is -0.5. If the expected return of Stock D is 8%, and the risk-free rate of return is 5%, what is the expected return of the market? A)+3.0%. B)-1.0%. C)+3.5% B — RRStock = Rf + (RMarket − Rf) × BetaStock, where RR = required return, R = return, and Rf = risk-free rate A bit of algebraic manipulation results in: RMarket = [RRStock − Rf − (BetaStock × Rf)] / BetaStock = [8 − 5 − (-0.5 × 5)] / -0.5 = 0.5 / -0.5 = -1% 9. If the risk-free rate of return is 3.5%, the expected market return is 9.5%, and the beta of a stock is 1.3, what is the required return on the stock? A)7.8%. B)11.3%. C)12.4%. B — The formula for the required return is: ERstock = Rf + (ERM – Rf) × Betastock, or 0.035 + (0.095 – 0.035) × 1.3 = 0.113, or 11.3% 10. Given a beta of 1.25 and a risk-free rate of 6%, what is the expected rate of return assuming a 12% market return? A)10%. B)31%. C)13.5% C — k = 6 + 1.25 (12 − 6) = 6 + 1.25(6) = 6 + 7.5 = 13.5 11. Given the following information, what is the required rate of return on Bin Co? inflation premium = 3% real risk-free rate = 2% Bin Co. beta = 1.3 market risk premium = 4% A)7.6%. B)16.7%. C)10.2% C — Use the capital asset pricing model (CAPM) to find the required rate of return. The approximate risk-free rate of interest is 5% (2% real risk-free rate + 3% inflation premium). k = 5% + 1.3(4%) = 10.2% 12. Given a beta of 1.55 and a risk-ree rate of 8%, what is the expected rate of return, assuming a 14% market return? A)12.4%. B)17.3%. C)20.4% B — k = 8 + 1.55(14-8) = 8 + 1.55(6) = 8 + 9.3 = 17.3 13. The following information is available for the stock of Park Street Holdings: The price today (P0) equals $45.00. The expected price in one year (P1) is $55.00. The stock's beta is 2.31. The firm typically pays no dividend. The 3-month Treasury bill is yielding 4.25%. The historical average S&P 500 return is 12.5%. Park Street Holdings stock is: A)overvalued by 1.1%. B)undervalued by 3.7%. C)undervalued by 1.1% A — To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM). Step 1: Calculate Expected Return (Holding period return): The formula for the (one-year) holding period return is: HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price. Here, HPR = (0 + 55 – 45) / 45 = 22.2% Step 2: Calculate Required Return: The formula for the required return is from the CAPM: RR = Rf + (ERM – Rf) × Beta RR = 4.25% + (12.5 – 4.25%) × 2.31 = 23.3%. Step 3: Determine over/under valuation: The required return is greater than the expected return, so the security is overvalued. The amount = 23.3% − 22.2% = 1.1% 14. A stock that plots below the Security Market Line most likely: A)has a beta less than one. B)is overvalued. C)is below the efficient frontier. B — Since the equation of the SML is the capital asset pricing model, you can determine if a stock is over- or underpriced graphically or mathematically. Your answers will always be the same. Graphically: If you plot a stock’s expected return on the SML and it falls below the line, it indicates that the stock is currently overpriced, causing its expected return to be too low. If the plot is above the line, it indicates that the stock is underpriced. If the plot falls on the SML, it indicates the stock is properly priced. Mathematically: In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return 15. Mason Snow, CFA, is an analyst with Polari Investments. Snow's manager has instructed him to put only securities that are undervalued on the buy list. Today, Snow is to make a recommendation on the following two stocks: Bahre (with an expected return of 10% and a beta of 1.4) and Cubb (with an expected return of 15% and a beta of 2.0). The risk-free rate is at 7% and the market premium is 4%.Snow places: A)only Cubb on the list. B)neither security on the list. C)only Bahre on the list B — In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return. Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flow or dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate - risk free rate). For Bahre: ER = 10% (given), RR = 0.07 + (1.4)(0.11-0.07) = 12.6%. Stock is overpriced - do not put on buy list. For Cubb: ER = 15%, (given) RR = 0.07 + (2.0)(0.11-0.07) = 15%. Stock is correctly priced - do not put on buy list (per Snow's manager) 16. An analyst wants to determine whether Dover Holdings is overvalued or undervalued, and by how much (expressed as percentage return). The analyst gathers the following information on the stock: Market standard deviation = 0.70 Covariance of Dover with the market = 0.85 Dover’s current stock price (P0) = $35.00 The expected price in one year (P1) is $39.00 Expected annual dividend = $1.50 3-month Treasury bill yield = 4.50%. Historical average S&P 500 return = 12.0%. Dover Holdings stock is: A)overvalued by approximately 1.8%. B)undervalued by approximately 2.1%. C)undervalued by approximately 1.8% A — To determine whether a stock is overvalued or undervalued, we need to compare the expected return (or holding period return) and the required return (from Capital Asset Pricing Model, or CAPM). Step 1: Calculate Expected Return (Holding period return) The formula for the (one-year) holding period return is: HPR = (D1 + S1 – S0) / S0, where D = dividend and S = stock price. Here, HPR = (1.50 + 39 – 35) / 35 = 15.71% Step 2: Calculate Required Return The formula for the required return is from the CAPM: RR = Rf + (ERM – Rf) × Beta Here, we are given the information we need except for Beta. Remember that Beta can be calculated with: Betastock = [covS,M] / [σ2M]. Here we are given the numerator and the denominator, so the calculation is: 0.85 / 0.702 = 1.73. RR = 4.50% + (12.0 – 4.50%) × 1.73 = 17.48%. Step 3: Determine over/under valuation The required return is greater than the expected return, so the security is overvalued. The amount = 17.48% − 15.71% = 1.77% 17. Charlie Smith holds two portfolios, Portfolio X and Portfolio Y. They are both liquid, well-diversified portfolios with approximately equal market values. He expects Portfolio X to return 13% and Portfolio Y to return 14% over the upcoming year. Because of an unexpected need for cash, Smith is forced to sell at least one of the portfolios. He uses the security market line to determine whether his portfolios are undervalued or overvalued. Portfolio X’s beta is 0.9 and Portfolio Y’s beta is 1.1. The expected return on the market is 12% and the risk-free rate is 5%. Smith should sell: A)both portfolios X and Y because they are both overvalued. B)portfolio Y only. C)either portfolio X or Y because they are both properly valued B — Portfolio X’s required return is 0.05 + 0.9 × (0.12-0.05) = 11.3%. It is expected to return 13%. The portfolio has an expected excess return of 1.7% Portfolio Y’s required return is 0.05 + 1.1 × (0.12-0.05) = 12.7%. It is expected to return 14%. The portfolio has an expected excess return of 1.3%. Since both portfolios are undervalued, the investor should sell the portfolio that offers less excess return. Sell Portfolio Y because its excess return is less than that of Portfolio X 18. An investor believes Stock M will rise from a current price of $20 per share to a price of $26 per share over the next year. The company is not expected to pay a dividend. The following information pertains: RF = 8% ERM = 16% Beta = 1.7 Should the investor purchase the stock?. A)No, because it is undervalued. B)No, because it is overvalued. C)Yes, because it is undervalued C — In the context of the SML, a security is underpriced if the required return is less than the holding period (or expected) return, is overpriced if the required return is greater the holding period (or expected) return, and is correctly priced if the required return equals the holding period (or expected) return. Here, the holding period (or expected) return is calculated as: (ending price – beginning price + any cash flows/dividends) / beginning price. The required return uses the equation of the SML: risk free rate + Beta × (expected market rate − risk free rate). ER = (26 − 20) / 20 = 0.30 or 30%, RR = 8 + (16 − 8) × 1.7 = 21.6%. The stock is underpriced therefore purchase 19. A stock's abnormal rate of return is defined as the: A)rate of return during abnormal price movements. B)actual rate of return less the expected risk-adjusted rate of return. C)expected risk-adjusted rate of return minus the market rate of return. B — Abnormal return = Actual return – expected risk-adjusted return