![Intermediate Financial Management (MindTap Course List)](https://www.bartleby.com/isbn_cover_images/9781337395083/9781337395083_largeCoverImage.gif)
Concept explainers
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions:
Construct a plausible graph that shows risk (as measured by portfolio standard deviation) on the x-axis and expected
![Check Mark](/static/check-mark.png)
Want to see the full answer?
Check out a sample textbook solution![Blurred answer](/static/blurred-answer.jpg)
Chapter 3 Solutions
Intermediate Financial Management (MindTap Course List)
- Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolio performance, indicated that it may not be possible to evaluate portfolio management ability if there is an error in the benchmark used.a. In evaluating portfolio performance, describe the general procedure, with emphasis on the benchmark employed.b. Explain what Roll meant by benchmark error and identify the specific problem with this benchmark.c. Draw a graph that shows how a portfolio that has been judged as superior relative to a “measured” security market line (SML) can be inferior relative to the “true” SML.d. Assume that you are informed that a given portfolio manager has been evaluated as superior when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite Index. Explain whether this consensus would make you feel more comfortable regarding the portfolio manager’s true ability.e. Although conceding the possible problem with benchmark errors as set forth…arrow_forwardWhat is the answer to this question? For this question I have seen 2 answers. So im not sure whats right. Answer 1: The most relevant figure is (a) that reflects the risk-return characteristics of stock A and stock B. an effective frontier is called relationship between risk (standard deviation) and expected return. The shape of risk-return features is curved because for each incremental risk incurred there are raising marginal returns. Therefore, for each unit of risk, the standard deviation applied to the portfolio provides an extremely low amount of return. Also we can see that the SD of stock B is higher than that of A. Figure b) is incorrect because the returns don’t rise in proportion to the risk assumed. Figure c) is incorrect since both stocks stock A and stock B are risky, and thus a finite return cannot occur at standard deviation = 0 Answer 2 Answer - Graph B Correlation = Covariance / (Standard deviation of A x Standard deviation of B) Correlation = 0.0014 / (0.032 x 0.044)…arrow_forwardWhich of the following statements concerning the Efficient Market Hypothesis is correct? Select one: a. Stock market prices are based on speculation not on underlying information b. New information that confirms investor expectations should change stock prices c. Stock prices should slowly respond when unexpected information becomes available d. Careful research can help investors earn abnormal profits e. Your return on investment should reflect the riskiness of your portfolioarrow_forward
- what are the challenges faced by an investment advisor in managing investor expectations in volatile market conditions? Additionally, can you validate the statement: According to Harry Markowitz, the risk of well-diversified portfolio is less than the risk of the candidate used in the portfolio.arrow_forwardWhen working with the CAPM, which of the following factors can be determined with the most precision? a. The most appropriate risk-free rate, rRF. b. The market risk premium (RPM). c. The beta coefficient, bi, of a relatively safe stock. d. The expected rate of return on the market, rM. e. The beta coefficient of "the market," which is the same as the beta of an average stock.arrow_forwardYou are an investment analyst at an asset management firm. Your colleague, the in-house economist, has analyzed all the risky securities in your economy - A, B and C. He provides you with the following statistics: A B C Risk-Free Securities Expected Returns Standard Deviation 0.25 0.20 0.12 0.12 0.11 0.08 0.01 The Correlation between A and B is 0.25, between B and C is 0.75, and between A and C is 0.5. What is the slope of the capital market line in this economy? Group of answer choices 0.27 0.58 0.62 0.66 052arrow_forward
- A portfolio consisting of two assets has a correlation coefficient of 0.7. Another two-asset portfolio has a correlation coefficient of -0.6. In the absence of any other information, which portfolio should you invest in, if your main goal is to eliminate risk? Justify your reasoning. How does your answer change if your main goal is to take a certain market view and hence make a side bet? Explain more generally the advantages and disadvantages of using correlation in the decision-making process within a portfolio management context. Make sure to mention what correlation is, and what is not, as a metric tool for investment decisions.arrow_forwardBart Campbell, CFA, is a portfolio manager who has recently met with a prospective client, Jane Black. After conducting a survey market line (SML) performance analysis using the Dow Jones Industrial Average as her market proxy, Black claims that her portfolio has experienced superior performance. Campbell uses the capital asset pricing model as an investment performance measure and finds that Black’s portfolio plots below the SML. Campbell concludes that Black’s apparent superior performance is a function of an incorrectly specified market proxy, not superior investment management. Justify Campbell’s conclusion by addressing the likely effects of an incorrectly specified market proxy on both beta and the slope of the SML.arrow_forwardWhen describing the attitude of investors towrds risk, which statement is correct? A.Investors may behave as though they are risk seekers for small investments B.For a risk-averse investor, the standard deviation of the return distribution is a relevant measure of risk C.Investors behave as though they are risk averse for investments of significant size D.All of the abovearrow_forward
- When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient of "the market," which is the same as the beta of an average stock. b. The beta coefficient, bi, of a relatively safe stock. c. The market risk premium (RPM). d. The most appropriate risk-free rate, rRF. e. The expected rate of return on the market, rM.arrow_forwardWhich of the following statements is CORRECT? 1. a. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time. 2. d. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable. 3. c. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM. 4. e. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller. 5. b. Richard Roll has argued that it is possible to test the CAPM to see if it is correctarrow_forwardAnswer whether each of the following statements is correct and explain your argument. \ (a) According to CAPM, the expected return of a risky asset is larger than the risk free rate. (b) According to CAPM, the expected return of a risky asset increases with its variance. (c) According to the separation property, the optimal risky portfolio for an investor dependson the investor’s personal preference. (d) A less risk-averse investor has a steeper indifference curve for the utility function.arrow_forward
![Text book image](https://www.bartleby.com/isbn_cover_images/9781337909730/9781337909730_smallCoverImage.gif)